Shale's Lesson for Creditors and Debtors

The heavy hand of past borrowings continues to hang over us. China's explosion of debt is worrisome. The bad loans being carried by European banks may be a factor restraining the willingness to lend. The IMF and the EU are still at odds over the sustainability of Greek debt.

Meanwhile, data released yesterday showed that household debt in the US surpassed the pre-crisis peak in Q1 (to ~$12.7 trillion). Arrears sharply lower than before, with the notable exception of student loans. Also, there has been some recent slippage on credit cards and vehicle loans.

The way in which debt is addressed shapes the subsequent expansion. What happened to the US shale industry may offer insight that can be applied more broadly. This is not some plea about forbearance or forgiveness. It is about capital markets and the legal system.

Here is the quick backstory: Shale was booming on the back of high oil prices and financed on debt. When oil prices fell, the debt proved onerous. Almost 115 exploration and production (E&P) businesses were driven into bankruptcy in 2015-2016. The Financial Times recently reported that eight of the 10 largest have emerged from bankruptcy and are operating.

These shale companies have cut billions of dollars of debt. They have stronger balance sheets than before. Output was cut, but it appears to have bottomed and begun growing again. Often the companies retained their management. Some of the assets (fields) that had to be liquidated are in stronger (better capitalized) hands.

This limits the impact of bankruptcy on rationalizing an industry by getting rid of capacity and inefficient (high cost) producers. The industry itself appears to be going in a powerful upswing of technological advances and innovations that have seen costs continue to fall. There is an important lesson in there for OPEC's efforts to drive out US shale production.

US bankruptcy law may be lenient compared with other major countries. Culturally, the US also seems to have de-stigmatized business failures. Often those who fail try again.

One of the implications of this is that investors return quicker than one may have envisioned. Equity capital raised by the sector was a record high in 2016 and bond issuance increased though not to record levels. The return of investor in an environment of liberal bankruptcy laws requires advanced risk management and portfolio construction tools.

Excess capacity and business failures cannot be avoided. However, the process can be routinized, managed, and de-stigmatized. It may be hard to imagine this for people who the word debt and guilt have similar origins and sound. Even many Americans don't seem to know what to make of it.

It is like a sport, like football, basketball, or hockey, where the violation of the rules (foul or penalty) is incorporated into the game itself. Sometimes the penalty for violating the rules (making someone shoot from the free throw line) is preferable to the other outcome (an easy lay-up). Rarely is there an ethical or moral issue that arises from a foul in basketball, or a penalty in football or hockey. Bankruptcy forces both creditor and debtor to deal with the issue so they both can get on with it. The foul shot is made (or not), the penalty is served, the flag given, and the game goes on.

The combination of US bankruptcy laws, the culture around it, and developed capital markets helped facilitate the recovery of the US shale industry. It demonstrates an ability to harness these different forces and flexibility that is not strictly American, but characteristically American. The flexibility of the US labor often comes down to the ease with which business can hire and fire, but otherwise, seems exaggerated. The key it seems is the flexibility of capital, not labor. Capital has to admit it is wrong and takes its loss. Prudent investment allows for managed losses. There may be something here that can done with Chinese characteristics.

If we are to pay no mind Shakespeare's suggestion that “neither a borrower nor lender be” then it is incumbent on us to create incentive structures for timely conflict resolution. The inability to do this is arguably an important constraint in Europe. Investors (and other producers) need to recognize that bankruptcy can be a way to reorganize the capital structure of business but not necessarily remove the capacity from the market.