It has always been known that the oil and gas industry only survives by way of debt financing. Fracking is capital intensive, and very few companies involved ever actually even turn a profit in excess of the cost of capital.
Instead, they have always operated by dependency on cheap money from Wall Street banks to finance their drilling and operations.
Fred Nathan is the executive director of Think New Mexico, an independent nonpartisan statewide think tank whose mission is “to improve the quality of life for all New Mexicans, especially those who lack a strong voice in the political process.” Nathan said that the contraction of the oil and gas industry in New Mexico is a “cause for deep concern” for the state budget, because every time the price of a barrel of oil drops $1, the state’s general fund takes a $22 million hit.
“More than 40 percent of New Mexico’s general operating budget for the state comes from oil and gas revenue,” Nathan told Truthout. “Last session many legislators from both parties acknowledged that we have to be mindful that this is a volatile industry and we cannot rely on the price of oil and gas to remain stable.”
And this is also the case for many other states, such as Texas, California and Colorado, which have attached so much of their budget to revenue from allowing fracking within their borders.
Attorney, author and CPA Greg Rogers wrote the seminal book, Financial Reporting of Environmental Liabilities and Risks, as well as being a fellow and adviser to the Master of Accounting Program at the University of Cambridge in the U.K. “If the golden goose is going to die, it’s really important that you know that so you can anticipate it,” Rogers warned. “When do you get out of that game? You’d better be close to the exit door.”
Oil companies owe billions of dollars in asset retirement obligations (AROs) to the state, which are the oil and gas companies’ financial obligations to clean up and close their wells. But it is looking increasingly likely that, instead of the oil companies paying for the AROs, these are what states will be stuck with as companies file for bankruptcy.
Hence, states like New Mexico that tied so much of their budget to the fracking boom look like they are going to be without that money, plus needing hundreds of millions of dollars, possibly even billions, to close the wells if they are not successful in obtaining that money from the oil companies before they go bankrupt.
“But if the state does that, it might hasten the death of the oil industry in their state,” Rogers explained. “And there will be political consequences for that, and eventually the state is going to have to hand a big bill for the cleanup to its taxpayers.”
Which raises questions such as: Will social programs have to be sacrificed to fund these cleanup operations? And would states even have the money without the fracking generated revenue?
Rogers, who also worked as an adviser to oil giant BP and its auditors on liability estimates and disclosures arising from the Deepwater Horizon disaster, describes fracking as being “like a Ponzi scheme, it only works as long as you continue to get new suckers to sustain growth.”
The global spread of the COVID-19 virus has caused both supply and demand for global goods to plummet as factories are shuttered, workers stay home, and businesses are ordered to close or cut their hours drastically by states across the U.S. Jets are grounded as people cease traveling, and talk of an ongoing global recession, or even depression, is now commonplace.
Oil prices sank to nearly $20 per barrel, the lowest price in more than 18 years, due to the combination of the ongoing global pandemic coupled with an oil price war between Russia and Saudi Arabia, which has caused a supply glut – ironically, one that is also exacerbated by fracking itself. (Most oil companies in New Mexico that are fracking need oil to be $50 per barrel just to break even.)
The Financial Times recently ran a story which posited, “Oil crash only a foretaste of what awaits energy industry: The end of hydrocarbons as a lucrative business is a real possibility. We are seeing that in dramatic form in the current oil price crash.” Oil companies are already announcing major cuts in spending in response to the rapid devaluation of stock prices. American oil companies are now frantically racing to restructure their massive debt, as the price war appears poised to cause numerous bankruptcies across the entire shale patch. Seven of the most active companies involved in fracking in Texas have already cut $7.6 billion from their budgets as a response to the oil price collapse.
New Mexico’s fracking boom appears poised to fall off an economic cliff.
“You are paying back the old suckers with the money you got from the new suckers, with a return,” Rogers said. “So that’s the fundamental problem on the production side of fracking. It’s just not productive when you factor in the cost of capital. Eventually, everyone figures out that game and the whole system crashes, and I think that’s where we are right now.”
And it is this industry (the vast majority of it in the form of fracking in New Mexico) from which New Mexico Gov. Michelle Lujan Grisham is drawing more than 25 percent of the revenue for the state budget.
Fracking Always Destined for Failure
Rob Schuwerk, former assistant attorney general for New York State, is the executive director of Carbon Tracker North America. London-based Carbon Tracker is a think tank researching the impact of the climate crisis on financial markets. A graduate of Yale Law School, Schuwerk is also a former securities litigator, and one of his specialties is analyzing which remaining oil and gas production projects might remain economically viable in the future.
Even before coronavirus or the oil price war, the climate crisis was already in the process of causing numerous companies involved in fracking to be looking at bankruptcy.
As Schuwerk sees it, the bottom is dropping out, showing investors that while investing in anything oil and gas is bad, investing in fracking is even worse.
“When we had a 1 to 2 percent drop in demand in 2014, oil prices halved,” he told Truthout. “So that kind of demand as a permanent thing might result in a fairly low oil price, in which case a lot of these fracking firms would be left without free cash flow money.”
This appears to be happening now, with New Mexico’s state budget on the chopping block, and things will likely get even worse once companies begin to file for bankruptcy. Schulwerk explained that there will be large numbers of what are called “orphaned wells,” which occur when a company goes bankrupt and cannot pay for cleaning them up and closing them.
“So, if the companies don’t or can’t do it, the state and taxpayers have to foot the bill,” Schuwerk said. “And that is a big problem a lot of people aren’t thinking about.”
Historically, oil companies own all the assets that grow as price and demand for oil continue to increase, allowing the companies to use the proceeds from sales of future oil to pay for the decommissioning of their wells after they have run their useful lives. But this was never going to work as far as making an energy transition away from oil and gas, which much of the rest of the world is already in the process of doing.
“In the energy transition, there is a wave of liability that will come due at exactly the wrong time, when these companies are looking at a market that is shrinking,” Schuwerk said.
Thus, as both Schuwerk and Rogers warn, the state and its taxpayers are going to be stuck with the cleanup costs, as the coronavirus and a global price war simultaneously cause tax revenue to evaporate.
Rogers isn’t the only person who sees fracking as a legal Ponzi scheme.
Journalist Bethany McLean, known for her investigation into the Enron scandal and the 2008 financial crisis, who has also been a columnist for Fortune magazine, sees it similarly.
In a 2018 interview on “The New Yorker Radio Hour,” McLean asked how much energy oil and gas companies could produce via fracking without their being funded with cheap capital from Wall Street.
“I don’t know from a financial standpoint that it ever becomes a calamity, but it becomes a calamity if we depend on this oil and gas and think it’s going to grow forever,” she told the host. “People forget about the idea that somebody had to pay the money back. And so, I think there is an analogy to this today when I get asked the question, ‘Why on Earth would Wall Street fund these guys [frackers] if it’s this uneconomic? You must be wrong.’ I say no, no, no, just look at the history of Wall Street: they’ve funded plenty of things that are uneconomic at the end of the day.”
Rogers says that when the growth stops and oil prices crash, as they are doing, we will see how bad the existing wells really are, as companies will be unable to mask them with new production.
“When states are counting on that revenue and jobs they bring in, like New Mexico, all [of a] sudden you get a big surprise at the end of this when it crashes,” he said.
Hence, the parts of the oil and gas industry involved in fracking only function when the long-term outlook for oil prices is positive, and Rogers sees this as the endgame. “I think what we are entering now because of the climate crisis and these other crises is a permanent decline of the U.S. oil industry,” he said.
Like Schuwerk, Rogers sees a confluence of collapsing events occurring simultaneously. “These decommissioning obligations are due when an oil well becomes non-economic, when it costs more to produce the barrel than you can sell it for,” he said. “And you are pulling forward in time the decommissioning costs of these wells, and this is happening at exactly the same time many companies are going broke. And it can’t happen any other way.”
The End of the Golden Goose
According to Nathan, New Mexico’s state legislature increased general fund spending approximately 20 percent over the last two years. He also told Truthout that New Mexico’s general fund revenues from all sources increases by about 3 percent annually and spending has increased by 3 percent because New Mexico’s Constitution requires a balanced budget.
But the converging crises are forcing the issue now.
Rogers sees what he calls a “tsunami of bankruptcies” across New Mexico, Colorado and California that appear imminent. The earthquake in this case is the peaking demand for oil and gas. “The tsunami, then, is all the asset retirement obligations that come sweeping in after the earthquake that a lot of people hadn’t anticipated,” he said.
But Rogers also gave another warning: “The interesting twist is from financial markets that are always looking ahead and pricing in futures. If the markets become keenly aware of the impending tsunami, they will price this into current costs, in which case the tsunami accelerates the earthquake.”
Rogers continues, “Say you are JP Morgan and lend oil and gas a lot of cash, and you figure out this is a permanent decline in the industry, and there is $400 billion of ARO debt out there, and most of that is positioned ahead of you to pay states before you get paid,” Rogers said. “Do you want to keep loaning money? Not likely. So that would be a way of the tsunami causing the earthquake. I think that is what is going to happen here.”
What Should New Mexico Do?
In early 2020, Governor Lujan Grisham and legislators took $320 million and placed it into a new endowment for early childhood education, instead of leaving it in the budget where the money could have been spent elsewhere.
“That was a really smart move,” Nathan said. “Critics said that was too much money for a new endowment and wanted to divert some of that for more General Fund spending. In retrospect, those same critics probably now wish that more had been put in that endowment and less for General Fund spending.”
Nathan believes the governor and legislature may need to hold a special session between now and July 1 to balance the state budget, given that right now the budget assumes oil is $50 per barrel, and at the time of this writing, it is less than half that.
On March 19, New Mexico’s GOP called for a special session as economic impacts from the virus have already started befalling the state.
Nathan sees whatever budget New Mexico can come up with for 2021-2022 being far more conservative than at present, coupled with a dramatic spending reprioritization. It is not out of the realm of possibility that the current state budget of $7.6 billion could drop by about $1.5 billion to $6 billion if the current trajectory of economic downturn caused by the COVID-19 pandemic continues.
“That will impact every New Mexican, and it will be virtually impossible for that to not impact public schools, along with higher education, as those two right now are about three-fifths of the budget,” Nathan said.
While New Mexico is already moving in the direction of bonding, Schulwerk doesn’t believe the state has gone far enough in order to cover itself.” All these regulators are coming to this problem late and should have had these regulations in place all along.”
Rogers believes that in order to be financially and environmentally responsible, New Mexico must figure out its true financial exposure to ARO defaults, because at present, the state does not know how much money the fracking companies will owe it when they shut down their wells.
Rogers also says New Mexico must contend with understanding how likely it is the companies will be able to pay back their environmental debt. “That is related to how much more time are these guys [oil and gas companies] going to be beholden to the golden goose,” he said. “If I calculate that time is growing nigh, how do I gain first mover advantage of getting my money out of these guys before everyone else does? They don’t just operate in New Mexico; they operate in other states with other creditors. There is some advantage to be had by moving first, to try to get the lion’s share of what you are owed before everyone else does.”
The long-term outlook for the global oil and gas industry, given the climate crisis and now the global pandemic, does indeed look bleak. Additionally, given that Saudi Arabia and Russia have large petroleum reserves and the lowest production costs in the world, the current oil glut does not bode well, according to Rogers.
“They are saying, If climate change and the energy transition means that oil is to be left in the ground, it’s not going to be our oil that goes unburned,” he said. “The U.S. can’t survive a sustained price war, and they know it.”
From Rogers’s perspective, New Mexico’s time to extract itself from the dying industry it has tied so much of its budget to, is now.
“The coronavirus is an ideal opportunity for Russia and Saudi Arabia to do what is in their economic interest and also within their power — bury the U.S. oil and gas industry involved in fracking once and for all.”