The Power and the Money

The Barber of Buenos Aires cuts again

Argentina is going to get a large haircut on its debt. That was a foregone conclusion. Now, though, Covid-19 has worsened the situation. Yet for some reason Argentina has made a very generous opening offer, about what I would have expected in a world without a pandemic. I don’t know why.

The country could not have paid before Covid-19 hit; it certainly can’t pay now. So President Fernández’s finance minister, Martín Guzmán, proposed a debt restructuring that was far more generous than most economists expected.

Of course, restructuring the debt is ultimately a political decision, and economists still aren’t too good at predicting political decisions. That said, economists do think the offer is pretty generous towards creditors.

First, how generous? I came up with a back-of-the-envelope calculation for at least a chunk of the outstanding private debt. We know the following:

• The face value of that debt is going to cut from $67 billion to $63 billion, or 5.4%;
• The total interest that will be paid on that debt before its retired (or rolled over) is going to be cut from $61 billion to $23 billion;
• Coupon payments will be suspended for three years, after which they will rise slowly from 0.5% in 2023 to a maximum of 4.5%.

If you assume that the coupon rate will rise by 0.5 percentage points per year, then it is possible to estimate a flow of payments and discount that back to year zero. You can do that for the original flow of payments and the restructured flow in order to estimate the “haircut” on the debt. Of course, in order to do that you need a discount rate. What to use? You could use the current yield on Argentine debt, which is in the vicinity of 40%, but that number reflects the fact that everyone knows that the country can’t possibly repay its current debt load. You could use the rate at which most of the debt was issued at, around 7%, but that reflects the optimism of the Macri years and does not reflect the country’s likely post-restructuring situation.  

At 40%, the haircut comes to 90%! That can’t be right. At 6.7%, the haircut comes to 49%, but that waves away the fact that Argentina is riskier now. There is a lot of chatter for a 12% rate, which sounds right. Using that, you get a haircut of 60%. Which is still less than Argentina got back in 2005.

Why be so generous?

The Trump administration is not joining OPEC and the deal will not last

The United States is not joining OPEC. The United States is not leading a cartel to raise oil prices. The United States is, to quote my 5-year-old daughter, “not doing nothing.” The President of the United States is posturing.

Right now, the Trump administration is doing absolutely nothing to jawbone U.S. producers into cutting. In fact, it’s made it clear that U.S. “cuts” will come from market forces. It is remotely possibly that the Texas Railroad Commission (RRC) will order production cuts in Texas, but right now only one of the three commissioners supports the move and hearings about the idea have been contentious, to say the least. Moreover, what would be the point? If a putative 9.7 million bpd cut didn’t move markets, why would anything Texas could do make a difference?

It seems to be true that Trump worked the phones to get the Saudis to accept an agreement. But OPEC has no enforcement power and all the low-cost producers have incentives to cheat. Moreover, the deal is almost a sham. Both Russia and Saudi cut from a baseline level of 11 million bpd (the link goes to the OPEC press release) … but Saudi has never hit that level. The supposed highs of 12 million bpd included sales of stored Saudi crude. Ultimately, Saudi production will be down only 1.2 million bpd.

So good luck with enforcing that deal. As with so much of the Trump administration, this is for show. He gets to show off much he’s in with the Saudis and the Russians, and he gets to tell his backers in the oil industry that he went to bat for them. Good for him, I suppose. But it isn’t much of a cartel and the U.S. government isn’t ordering any production cuts at all. With Covid-19 having destroyed oil demand, prices are not going to go up anytime soon, least because of this deal. 

Covid-19 and American oil production, in gory institutional detail

Oil prices are crashing due to Covid-19. So what happens to American output?

Market reactions first, then political ones.

Well, first the oldest building in Dallas, circa 2019:

Yes, my shoes are bright blue.

Now market reactions to the Covid oil price crash.

Market

The “shut-in prices” is the minimum wellhead price operators need to continue producing from a production well. It’s equal to the amount needed to cover ongoing O&M, including where-necessary pumping and artificial lift, as well as water, gas and steam flooding and other secondary recovery costs.

The first wells to shut down are “stripper wells” nearing the end of their useful life. In the U.S. there are about 400,000 of these wells producing about 720,000 barrels per day. (I said they were small.) They usually rely on pumps to get the stuff out of the ground, meaning those famous mechanical donkeys you can still see in parts of California.

Next to go are wells that depend on secondary recovery. For example, in the Golden State companies inject about 400 million barrels of steam every year to get 161 million barrels of oil. (Governor Newsom has banned new wells using this technique.) These wells are high cost, but when shut down they tend to fill up fast with water. Companies that shut them down risk losing the remaining shut-in oil forever. In addition, companies that shut down wells risk losing their land leases. As a result, these wells don’t close immediately once they start losing money.

After that some wells will start to decline quickly in the absence of new drilling. Tight oil wells in North Dakota decline 65% in the first year and 77% over the first two years. That’s the next to go. In their early phase, however, tight oil wells can be easily shut-in and restarted. So tight oil production will decline in two waves, first by natural decline as new drilling collapses and then again as companies shut wells down. Since you can restart unconventional wells in about a week companies won’t be as reticent to stop production … if not for the fact that most of them are highly indebted and desperate for any sort of cash flow to satisfy demanding creditors.

This chart for tight oil plays in the Eagle Ford region of Texas gives you some idea of just how fast this decline can happen. Without new drilling, production would decline by about 700,000 bpd within a year from this play alone:

But production will decline faster than that, because unconventional wells can be shut-in fairly easily during their first year. 

In other words, the current oil price crash will cause U.S. production to drop, and drop fast. That is, it will if it is sustained. That’s not a given: countries have already begun to reopen their economies. Oil demand will recover as a result, possibly to prices that might keep tight oil production alive and stop the shuttering of stripper wells.

Political

Of course, state governments can act via a process called “proration,” whereby they can order well-by-well output cuts. Back in the 1930s, Congress passed the Connally Act, which made it illegal to ship oil across state lines in violation of state output quotas. It also created the Interstate Oil Compact Commission (here is the law), which brought representatives together from oil-producing states to hammer out overall quotas, America’s own little mini-OPEC before OPEC. (For whatever reason, Illinois and California never passed proration laws, although the California government sanctioned a quasi-private commission that functioned outside the law.)

The IOCC still exists, but its powers have withered. It no longer makes decisions by majority vote. And it now includes 31 states, five Canadian provinces, two Canadian territories, plus Egypt (W?) and the other Georgia (WT??) and the Bolivarian Republic of Venezuela (WTF???). Plus, while Arkansas, Colorado, Michigan, New Mexico, Oklahoma, and Texas all passed proration laws, only Oklahoma and Texas still exercise the muscles. (The Rail Road Commission of Texas and the Oklahoma Corporation Commission still publish quotas, set above most wells’ maximum production.) Executive agencies function like muscles: use ‘em or lose ‘em. Those states would need to design regulations from scratch to impose quotas, and they would certainly be challenged in court.

Now, Texas is big enough on its own to mandate a production cut. And the Texan authorities are talking about it! But it’s all talk. And there’s no sign of the Trump administration trying to resuscitate the Depression-era laws that let it coordinate oil production cuts, or even coordinating talks among the IOCC states. But production is falling fast, so Trump could claim that he jawboned producers into it.

Hell, he could do that even if production wasn’t falling fast. That’s his M.O.

Conclusion

Which means that the ultimate question is whether OPEC wants to be fooled. If Saudi Arabia thinks that letting Mexico de facto defect while pretending to cooperate will not hurt their cartel agreement, then they’ll accept the bullshit. If they don’t, then they’ll reject the Trump-AMLO bamboozle.