Over the last few weeks, a number of regular readers of
The Archdruid Report have asked me what I think about the
recent plunge in the price of oil and the apparent end of the fracking bubble.
That interest seems to be fairly widespread, and has attracted many of the
usual narratives; the blogosphere is
full of claims that the Saudis crashed the price of oil to break the US
fracking industry, or that Obama got the Saudis to crash the price of oil to
punish the Russians, or what have you.
I suspect, for my part, that what’s going on is considerably
more important. To start with, oil isn’t the only thing that’s in steep
decline. Many other major commodities—coal, iron ore, and copper among
them—have registered comparable declines over the course of the last few
months. I have no doubt that the Saudi government has its own reasons for
keeping their own oil production at full tilt even though the price is
crashing, but they don’t control the price of those other commodities, or the
pace of commercial shipping—another thing that has dropped steeply in recent
months.
What’s going on, rather, is something that a number of us in
the peak oil scene have been warning about for a while now. Since most of the
world’s economies run on petroleum products, the steep oil prices of the last
few years have taken a hefty bite out of all economic activities. The consequences of that were papered over
for a while by frantic central bank activities, but they’ve finally begun to
come home to roost in what’s politely called “demand destruction”—in less
opaque terms, the process by which those who can no longer afford goods or
services stop buying them.
That, in turn, reminded me of the last time prolonged demand
destruction collided with a boom in high-priced oil production, and sent me
chasing after a book I read almost three decades ago. A few days ago,
accordingly, the excellent interlibrary
loan service we have here in Maryland brought me a hefty 1985 hardback by
financial journalist Philip Zweig, with the engaging title Belly Up:
The Collapse of the Penn Square Bank. Some of my readers may never
have heard of the Penn Square Bank; others may be scratching their heads,
trying to figure out why the name sounds vaguely familiar. Those of my readers
who belong to either category may want to listen up, because the same story
seems to be repeating itself right now on an even larger scale.
The tale begins in the middle years of the 1970s, when oil
prices shot up to unprecedented levels, and reserves of oil and natural gas
that hadn’t been profitable before suddenly looked like winning bets. The deep
strata of Oklahoma’s Anadarko basin were ground zero for what many people
thought was a new era in natural gas production, especially when a handful of
deep wells started bringing in impressive volumes of gas. The only missing
ingredient was cash, and plenty of it, to pay for the drilling and hardware.
That’s where the Penn Square Bank came into the picture.
The Penn Square Bank was founded in 1960. At that time, as a
consequence of hard-earned suspicions about big banks dating back to the
Populist era, Oklahoma state banking laws prohibited banks from owning more
than one branch, and so there were hundreds of little one-branch banks
scattered across the state, making a modest return from home mortgages, auto
loans, and the like. That’s what Penn Square was; it had been organized by the
developer of the Penn Square shopping mall, in the northern suburbs of Oklahoma
City, to provide an additional draw to retailers and customers. There it sat,
in between a tobacconist and Shelley’s Tall Girl’s Shop, doing ordinary retail
banking, until 1975.
In that year it was bought by a group of investors headed by
B.P. “Beep” Jennings, an Oklahoma City banker who had been passed over for
promotion at one of the big banks in town. Jennings pretty clearly wanted to
prove that he could run with the big dogs; he was an excellent salesman, but
not particularly talented at the number-crunching details that make for long-term
success in banking, and he proceeded to demonstrate his strengths and
weaknesses in an unforgettable manner. He took the little shopping mall bank
and transformed it into a big player in the Oklahoma oil and gas market, which
was poised—or so a chorus of industry voices insisted—on the brink of one of
history’s great energy booms.
Now of course this involved certain difficulties, which had
to be overcome. A small shopping center bank doesn’t necessarily have the
financial resources to become a big player in a major oil and gas market, for
example. Fortunately for Beep Jennings, one of the grand innovations that has
made modern banking what it is today had already occurred; by his time, loans
were no longer seen as money that was collected from depositors and loaned out
to qualified borrowers, in the expectation that it would be repaid with
interest. Rather, loans were (and are) assets, which could (and can) be sold,
for cash, to other banks. This is what Penn Square did, and since their loans
charged a competitive interest rate and thus promised competitive profits, they
were eagerly snapped up by Chase Manhattan, Continental Illinois, Seattle
First, and a great many other large and allegedly sophisticated banks. So Penn
Square Bank started issuing loans to Oklahoma oil and gas entrepreneurs, a
flotilla of other banks around the country proceeded to fund those loans, and
to all intents and purposes, the energy boom began.
At least that’s what it looked like. There was a great deal
of drilling going on, certainly; the economists insisted that the price of oil
and gas would just keep on rising; the local and national media promptly
started featuring giddily enthusiastic stories about the stunning upside
opportunities in the booming Oklahoma oil and gas business. What’s more,
Oklahoma oil and gas entrepreneurs were spending money like nobody’s business,
and not just on drilling leases, steel pipe, and the other hardware of the
trade. Lear jets, vacation condos in fashionable resorts, and such lower-priced
symbols of nouveau richesse as overpriced alligator-hide cowboy boots were much
in evidence; so was the kind of high-rolling crassness that only the Sunbelt
seems to inspire. Habitués of
the Oklahoma oilie scene used to reminisce about one party where one of the
attendees stood at the door with a stack of crisp $100 bills in his hand and
asked every woman who entered how much she wanted for her clothes: every
stitch, then and there, piled up in the entry. Prices varied, but apparently
none of them turned down the offer.
It’s only fair to admit that there were a few small clouds
marring the otherwise sunny vistas of the late 1970s Oklahoma oil scene. One of
them was the difficulty the banks buying loans from Penn Square—the so-called
“upstream” banks—had in getting Penn Square to forward all the necessary
documents on those loans. Since their banks were making loads of money off the
transactions, the people in charge at the upstream banks were unwilling to make
a fuss about it, and so their processing staff just had to put up with such
minor little paperwork problems as missing or contradictory statements
concerning collateral, payments of interest and principal, and so on.
Mind you, some of the people in charge at those upstream
banks seem to have had distinctly personal reasons for not wanting to make a
fuss about those minor little paperwork problems. They were getting very large
loans from Penn Square on very good terms, entering into partnerships with Penn
Square’s favorite oilmen, and in at least some cases attending the
clothing-optional parties just mentioned. No one else in the upstream banks
seems to have been rude enough to ask too many questions about these
activities; those who wondered aloud about them were told, hey, that’s just the
way Oklahoma oilmen do business, and after all, the banks were making loads of
money off the boom.
All in all, the future looked golden just then. In 1979, the
Iranian revolution drove the price of oil up even further; in 1980, Jimmy
Carter’s troubled presidency—with its indecisive but significant support for
alternative energy and, God help us all, conservation—was steamrollered by
Reagan’s massively funded and media-backed candidacy. As the new president took
office in January of 1981, promising “morning in America,” the Penn Square
bankers, their upstream counterparts, their clients in the Oklahoma oil and gas
industry, and everyone else associated with the boom felt confident that happy
days were there to stay. After all, the economists insisted that the price of
oil and gas would just keep rising for decades to come, the most
business-friendly and environment-hostile administration in living memory was
comfortably ensconced in the White House; and investors were literally begging
to be allowed to get a foot in the door in the Oklahoma boom. What could
possibly go wrong?
Then, in 1981, without any fuss at all, the price of oil and
natural gas peaked and began to decline.
In retrospect, it’s not difficult to see what happened,
though a lot of people since then have put a lot of effort into leaving the
lessons of those years unlearnt. Energy
is so central to a modern economy that when the price of energy goes up, every
other sector of the economy ends up taking a hit. The rising price of energy
functions, in effect, as a hidden tax on all economic activity outside the
energy sector, and sends imbalances cascading through every part of the
economy. As a result, other economic sectors cut their expenditures on energy
as far as they can, either by conservation measures or by such tried and true
processes as shedding jobs, cutting production, or going out of business. All
this had predictable effects on the price of oil and gas, even though very few
people predicted them.
As oil and gas prices slumped, investors started backing
away from fossil fuel investments, including the Oklahoma boom. Upstream banks,
in turn, started to have second thoughts about the spectacular sums of money
they’d poured into Penn Square Bank loans. For the first time since the boom
began, hard questions—the sort of questions that, in theory, investors and
bankers are supposed to ask as a matter of course when people ask them for
money—finally got asked. That’s when the problems began in earnest, because a
great many of those questions didn’t have any good answers.
It took until July 5, 1982 for the boom to turn definitively
into a bust. That’s the day that federal
bank regulators, after several years of inconclusive fumbling and a month or so
of increasing panic, finally shut down the Penn Square Bank. What they
discovered, as they dug through the mass of fragmentary, inaccurate, and
nonexistent paperwork, was that Penn Square had basically been lending money to
anybody in the oil and gas industry who wanted some, without taking the trouble
to find out if the borrowers would ever be able to repay it. When payments
became a problem, Penn Square obligingly loaned out the money to make their
payments, and dealt with loans that went bad by loaning deadbeat borrowers even
more money, so they could clear their debts and maintain their lifestyles.
The oil and gas boom had in fact been nothing of the kind,
as a good many of the firms that had been out there producing oil and gas had
been losing money all along. Rather, it
was a Ponzi scheme facilitated by delusional lending practices. All those Lear jets, vacation condos,
alligator-skin cowboy boots, heaps of slightly used women’s clothing, and the
rest of it? They were paid for by money from investors and upstream banks, some
of it via the Penn Square Bank, the rest from other banks and investors. The
vast majority of the money was long gone; the resulting crash brought half a
dozen major banks to their knees, and plunged Oklahoma and the rest of the US
oil belt into a savage recession that gripped the region for most of a decade.
That was the story chronicled in Zweig’s book, which I
reread over a few quiet evenings last
week. Do any of the details seem familiar to you? If not, dear reader, you need
to get out more.
As far as I know, the fracking bubble that’s now well into
its denouement didn’t have a single ineptly run bank at its center, as the
Oklahoma oil and gas bubble did. Most of the other details of that earlier
fiasco, though, were present and accounted for. Sky-high fuel prices, check; reserves
unprofitable at earlier prices that suddenly looked like a winning deal, check;
a media frenzy that oversold the upside and completely ignored the possibility
of a downside, check; vast torrents of money and credit from banks and
investors too dazzled by the thought of easy riches to ask the obvious
questions, check; a flurry of drilling companies that lost money every single
quarter but managed to stay in business by heaping up mountains of unpayable
debt, check. Pretty much every square on the bingo card marked “ecoomic
debacle” has been filled in with a pen dipped in fracking fluid.
Now of course a debacle of the Penn Square variety requires
at least one other thing, which is a banking industry so fixated on this
quarter’s profits that it can lose track of the minor little fact that lending
money to people who can’t pay it back isn’t a business strategy with a long
shelf life. I hope none of my readers are under the illusion that this is
lacking just now. With interest rates stuck around zero and people and
institutions that live off their investments frantically hunting for what used
to count as a normal rate of return, the same culture of short-term thinking
and financial idiocy that ran the global economy into the ground in the 2008
real estate crash remains firmly in place, glued there by the refusal of the
Obama administration and its equivalents elsewhere to prosecute even the most
egregious cases of fraud and malfeasance.
Now that the downturn in oil prices is under way, and panic
selling of energy-related junk bonds and lower grades of unconventional crude
oil has begun in earnest, it seems likely that we’ll learn just how profitable
the fracking fad of the last few years actually was. My working guess, which is
admittedly an outsider’s view based on limited data and historical parallels,
is that it was a money-losing operation from the beginning, and looked
prosperous—as the Oklahoma boom did—only because it attracted a flood of
investment money from people and institutions who were swept up in the craze.
If I’m right, the spike in domestic US oil production due to fracking was never
more than an artifact of fiscal irresponsibility in the first place, and could
not have been sustained no matter what. Still, we’ll see.
The more immediate question is just how much damage the
turmoil now under way will do to a US and global economy that have never
recovered from the body blow inflicted on them by the real estate bubble that
burst in 2008. Much depends on exactly who sunk how much money into fracking-related
investments, and just how catastrophically those investments come
unraveled. It’s possible that the result
could be just a common or garden variety recession; it’s possible that it could
be quite a bit more. When the tide goes out, as Warren Buffet has commented,
you find out who’s been swimming naked, and just how far the resulting lack of
coverage will extend is a question of no small importance.
At least three economic sectors outside the fossil fuel
industry, as I see it, stand to suffer even if all we get is an ordinary
downturn. The first, of course, is the financial sector. A vast amount of money
was loaned to the fracking industry; another vast amount—I don’t propose to
guess how it compares to the first one—was accounted for by issuing junk bonds,
and there was also plenty of ingenious financial architecture of the sort
common in the housing boom. Those are going to lose most or all of their value
in the months and years ahead. No doubt the US government will bail out its
pals in the really big banks again, but there’s likely to be a great deal of
turmoil anyway, and midsized and smaller players may crash and burn in a big
way. One way or another, it promises to be entertaining.
The second sector I expect to take a hit is the renewable
energy sector. In the 1980s, as prices
of oil and natural gas plunged, they took most of the then-burgeoning solar and
wind industries with them. There were major cultural shifts at the same time
that helped feed the abandonment of renewable energy, but the sheer impact of
cheap oil and natural gas needs to be taken into account. If, as seems likely,
we can expect several years of lowerr energy prices, and several years of the
kind of economic downdraft that makes access to credit for renewable-energy
projects a real challenge, a great many firms in the green sector will struggle
for survival, and some won’t make it.
Those renewable-energy firms that pull through will find a
substantial demand for their services further down the road, once the recent
talk about Saudi America finds its proper home in the museum of popular
delusions next to perpetual motion machines and Piltdown Man, and the US has to
face a future without the imaginary hundred-year reserve of fracked natural gas
politicians were gabbling about not that long ago. Still, it’s going to take
some nimble footwork to get there; my guess is that those firms that get ready
to do without government subsidies and tax credits, and look for ways to sell
low-cost homescale systems in an era of disintegrating energy infrastructure,
will do much better than those that cling to the hope of government subsidies
and big corporate contracts.
The third sector I expect to land hard this time around is
the academic sector. Yes, I know, it’s not fashionable to talk of the nation’s
colleges and universities as an economic sector, but let’s please be real; in
today’s economy, the academic industry functions mostly as a sales office for
predatory loans, which are pushed on unwary consumers using deceptive marketing
practices. The vast majority of people who are attending US universities these
days, after all, will not prosper as a result; in fact, they will never recover
financially from the burden of their student loans, since the modest average
increase in income that will come to those graduates who actually manage to
find jobs will be dwarfed by the monthly debt service they’ll have to pay for
decades after graduation.
One of the core reasons why the academic industry has become
so vulnerable to a crash is that most colleges and universities rely on income
from their investments to pay their operating expenses, and income from
investments has taken a double hit in the last decade. First, the collapse of
interest rates to near-zero (and in some cases, below-zero) levels has hammered
returns across the spectrum of investment vehicles. As a result, colleges and
universities have increasingly put their money into risky investments that
promise what used to be ordinary returns, and this drove the second half of the
equation; in the wake of the 2008 real estate crash, many colleges and
universities suffered massive losses of endowment funds, and most of these
losses have never been made good.
Did the nation’s colleges and universities stay clear of the
fracking bubble? That would have
required, I think, far more prudence and independent thinking than the academic
industry has shown of late. Those institutions that had the common sense to get
out of fossil fuels for ecological reasons may end up reaping a surprising
benefit; the rest, well, here again we’ll have to wait and see. My working
guess, which is once again an outsider’s guess based on limited data and
historical parallels, is that a great many institutions tried to bail
themselves out from the impact of the real estate bust by doubling down on
fracking. If that’s what happened, the looming crisis in American higher
education—a crisis driven partly by the predatory loan practices mentioned
earlier, partly by the jawdropping inflation in the price of a college
education in recent decades, and partly by rampant overbuilding of academic
programs—will be hitting shortly, and some very big names in the academic
industry may not survive the impact.
