I imagine that deep in the bowels of the classically designed Marriner S. Eccles Federal Reserve Building on Constitution Avenue in D.C.,  there’s a cauldron constantly brewing and emitting bubbles—and not of the bath time quality.  The current bubble has flecks of clay and quartz and is full of the much hyped promise of natural gas—let’s call it the shale bubble—and it is rising forth from the same reckless monetary policies that has plagued the U.S. economy for at least the past 20 years.

The Federal Reserve—known as the Fed—has been the source of many bubbles. So when the bubbles burst, the Fed is at the epicenter of the resulting economic earthquake, and yes, the reverberations are felt across the whole U.S. economy, because, disturbingly, the entire economy is securely shackled to the Fed through power granted by the U.S. Government.  It’s a cycle of chaos that begins with the Fed’s power to control the money supply, and the dreadful policies it often puts in place whilst doing so. How does the cycle begin?

It’s all about interest rates. It begins when the Fed artificially lower interest rates below the natural market rate and injects newly created “printing press money” into the economy. According to Austrian Business Cycle theory, it is these distortions in the availability of credit (through low interest rates) that start the cycle. In order to understand this, it is vital to recognize what interest rates are supposed to indicate. Lower interest rates mean that there’s more capital to be lent out while higher interests rates means capital is scarce.  That’s what they SHOULD indicate, when based on a free market system. The problem is that when the Federal Reserve manipulates the interest rate instead of allowing it to be set by market forces, it sets off a series of unnatural events—because it essentially misrepresented what was going on in the marketplace by playing around with the interest rates. People start to borrow and expand their businesss. Expansion of faulty credit creates an illusionary boom (bubble) which inevitably leads to the dreadful bust that leads to harmful overconsumption of resources, and a drastic misallocation of capital and assets that could have potentially gone to more productive uses.

Now, you are thinking to yourself: what does this have to do with the shale industry? Artificially low interests rates set by the Fed have allowed shale and oil companies to accumulate massive amounts of wasteful debt.  As the Wall Street Journal notes, borrowing has increased about 55% for oil and gas companies recently. Because of low interest rates, investors are desperate to find yields for their investments so it has lead them to take on bigger risks — which has caused shale companies and investors to look to the junk bond market for funding.  The name [Junk Bond] speaks for itself.  Investors and companies that have financed these companies through risky junk bonds are losing money more rapidly as the price of oil plummets.

The oil and shale industry has plenty of symptoms that indicate that there’s a bubble waiting to be popped.  The shale industry has rapidly expanded their production and exploration for wells in the last half decade.  The amount of operating rigs have sky rocketed: 187 in May 2009 to 1,607 in October 2014.  This has led to an implosion of oil production, making the U.S. one of the largest exporters of oil in the world; 2014 was a record setting year for barrel output — making it one of the most productive year since 1986.  Unfortunately, these statistics don’t really tell the whole story: this artificial boom — which was funded by risky junk bonds — has lead to an overproduction of oil.  If oil prices keep dropping, the junk bonds won’t be able to be paid back, and these shale companies will start to become unprofitable which will lead to their demise.  It’s also important to note that most of the jobs from that have been created in the last half decade have come from shale states.

 

Depending on OPEC decisions on oil production and Fed chairwoman Janet Yellen’s decision to raise interest rates or use quantitative easing, the shale oil bubble will continue to deflate.  This will inevitably lead to a bust in the shale industry and the secondary industries that have been affected by this boom — such as junk bond market, steel, sand, etc.   After recent bursts in other industries, you would think that the FED would have learned their lesson.  Instead, it has engaged in the dubious policies already proven catastrophic. Time is limited for the shale industry, and it is only a matter of time before the bubble pops.  Like the other bubbles, this one will likely bring the economy back into recession.  Let’s just hope for the best.