How has the increased interest and activity in shale oil and gas drilling changed the financial dynamics of the energy industry, and why does the Fed care?

The technological advances of the last three to five years have substantially increased companies’ ability to recover previously known but unrecoverable resources from shale. These advances have dramatically increased the amount of oil and gas that can be derived from this type of rock formation, several huge deposits of which are located in the United States.

Of the four or five big US shale basins, two—the Marcellus and Utica—are in the Cleveland Fed’s region (Ohio, western Pennsylvania, the northern panhandle of West Virginia, and eastern Kentucky).

The big change is that today companies have shifted investment and production to shale deposits because they produce so much faster than other sources of oil and gas. Companies are drilling shale deposits known to have oil and gas within 7 to 10 days’ time. In contrast, offshore targets (or those for which companies drill beneath the seabed) often take 8 to 10 years to develop. With the shift to large shale deposits, companies are producing more oil and gas for the amount of money and time spent.

Why does the Federal Reserve care? This industry is expanding its presence in the United States and that expansion will help grow gross domestic production. Plus, banks are deciding the amounts they will lend to companies doing the drilling based on money the borrowers expect to make from reserves in the ground; essentially, banks must lend on estimates. Bank examiners at the Fed need to make sure banks are lending safely and soundly, and to do that we have to keep up with changes in industries that could affect bank lending. Given the way the shale boom is affecting revenue streams of exploration and development companies, the boom has influenced how we analyze oil- and gas-related reserve-based lending by banks.

There are risks to lending to this industry, but banks can mitigate them. The biggest risk for lenders is that the oil and gas industry is subject to volatile price swings that can affect companies’ ability to repay loans. If oil and gas prices drop below “breakeven,” where the price at which a unit of oil or gas sells is equal to the cost of producing that unit, companies will stop producing, which would mean they have less cash coming in. If that happens, as it did in 2014 and 2015, we could have companies struggling to repay debt, meaning banks could have credit issues and defaults. To protect themselves from the industry’s vulnerability to such price swings, banks are expected to do two things: loan only a conservative amount against estimated levels of production and also to “stress test,” or assess how loan repayments could be affected if commodity prices were to decline.