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The Disconnect between Productivity and Profits in U.S. Oil and Gas Extraction

U.S. oil and gas production boomed during the years leading up to the pandemic. From 2011 to 2019, oil production more than doubled and dry natural gas…

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U.S. oil and gas production boomed during the years leading up to the pandemic. From 2011 to 2019, oil production more than doubled and dry natural gas production rose by more than half. Remarkably, these gains occurred despite lackluster investment spending and hiring. Instead, higher production came largely from productivity gains, via wider adoption of fracking technologies. More recently, production recovered sluggishly from the pandemic downturn despite a quick recovery in prices. Our analysis in this post suggests that slower productivity growth and investors’ demand for higher returns have made U.S. firms willing to boost output only at a higher threshold oil price.

Productivity Drove a Boom in Oil and Gas Output

U.S. oil and gas production boomed during the years leading up to the pandemic. Real net output in the oil gas extraction industry more than doubled from 2011 to 2019 according to data published by the U.S. Bureau of Labor Statistics (BLS), a development shown by the top line of the chart below. The sharp rise in the BLS index was driven by an enormous increase in physical quantities. Crude oil production more than doubled over the period, while dry gas production rose by more than half. This growth came as a surprise as production had stagnated over the prior two decades.

Oil and gas extraction surged in the last decade

Chart plots the rise in real output, multifactor productivity, and real inputs from 1999-2021.
Source: U.S. Bureau of Labor Statistics. 
Notes: Real output is a composite of oil and gas extraction, taking account of the mix and value of specific oil and gas varieties. Real inputs are comprised of capital, labor, and intermediates, aggregated using production cost shares. The index also takes into account the mix and value of specific oil and gas product varieties. 

The chart also shows that the BLS measure of real inputs rose only modestly over the period. Instead, the boom was driven largely by productivity gains—by the efficiency with which capital, labor and intermediate inputs were used, rather than by their quantity. This conclusion can be quantified via the economic concept of multifactor productivity (MFP)—a measure of the portion of output growth not explained by combined growth in inputs. The intuition is that increases in MFP reflect technological and organizational changes that boost output for a given quantity of inputs.

According to the BLS data, real inputs to oil and gas extraction grew by only 18 percent from 2011 to 2019 (the gold line in our chart). Multifactor productivity, derived as a residual between output growth and input growth, was up by slightly over 70 percent over the period (blue line).

More detailed data show that input growth came largely from increased use of intermediates: energy, materials and purchased services. Capital inputs rose by only about 5 percent over the period, with investment spending mostly going to offset depreciation. Labor inputs actually declined, reflecting a drop in hours worked.

The oil and gas productivity boom owed to the adoption and refinement of fracking and related technologies. These technologies enabled producers to access oil and gas embedded in shale and other “tight rock” formations and to achieve remarkable gains in drilling efficiency. Indeed, data from the U.S. Energy Information Agency, seen in the chart below, show crude oil production per active well more than doubling from 2011 to 2019, and gas production per well rising 50 percent. Total wells in operation, meanwhile, remained essentially flat.

Fracking technology drove strong productivity gains

Chart plotting average gas and oil output per well, 2000-2020.
Source: U.S. Energy Information Agency.
Note: The chart shows average output per active well.

Strong Productivity Growth Didn’t Mean Higher Profits

It seems natural to think that strong productivity growth would mean strong profit growth. After all, firms can increase output without spending more on inputs. Events didn’t turn out that way.

Our estimate of economic profits, shown by the blue bars in the chart below, declined over the period, with persistent losses setting in after 2014. (We rely on our own estimate because the official U.S. profit data don’t include unincorporated businesses, which hold about half the sector’s capital stock.) This lackluster profit performance translated into subpar returns for investors. Indeed, the Energy Information Administration estimates that the return on equity for energy companies was consistently below the return for manufacturing companies throughout the fracking boom.

Higher productivity has not been reflected in higher profits

Sources: U.S. Bureau of Economic Analysis; U.S. Energy Information Agency; authors’ calculations.
Notes: Profits are equal to value added less labor compensation, depreciation, taxes on production net of subsidies, and net interest payments. Net interest payments are set equal to 65 percent of payments by the mining industry, since data for the oil and gas industry are not reported separately. Oil prices refer to WTI.

The mismatch between productivity and financial performance owes to weak prices. Oil and gas prices held near all-time highs from 2011 through late 2014 but then tumbled and remained low. In 2019, oil prices (the dotted black line in the chart) averaged 40 percent below their 2011 level. Natural gas prices at Henry Hub averaged 35 percent below their 2011 level. These price developments help explain why investment and hiring were so lackluster. What productivity growth gave, lower prices took away.
A comparison of 2019 with the situation in 2009 is also instructive. Oil prices were about the same in both years. Yet profits were lower in 2019, with higher input costs putting a lid on the industry’s financial performance despite remarkable productivity gains.

The Tepid Recent Response to Higher Energy Prices

The onset of the pandemic sent energy prices into a tailspin and sharp cutbacks in production and exploration followed. But prices recovered and, by March 2021, oil prices had risen to $63/barrel, above the 2019 average. Natural gas prices moved past their 2019 average even more quickly, by late 2020. Both oil and gas prices then continued to trend higher.

U.S. production and investment were slow to recover in spite of the bounce back in prices. Crude oil production in June 2022 was about 7 percent below its level in early 2020. Gas production was only barely above that level. And real capital expenditure in the second quarter for oil and gas extraction was down some 15 percent from its pre-pandemic pace.

Why did U.S. production and capital expenditure respond so sluggishly? We see three related explanations—with important implications for future oil and gas production.

Uncertainty. Before Russia’s invasion of Ukraine, there were plausible scenarios under which oil prices might fall: another pandemic-induced slowdown, easing of sanctions on Iran and Venezuela, or higher production from Saudi Arabia. In this connection, producers considered the sizeable losses in 2015 and 2020 and were reluctant to expand.

Investor pressure. The 2022:Q1 Dallas Fed Energy Survey asked firms about factors holding back production. The most common answer was investor pressure to maintain high returns, with almost a 60 percent share. Recent analyst discussions also emphasize this theme. Keeping capital spending low leaves more money to return to investors as dividends or to pay down debt. This investor pressure for “capital discipline” is of course connected with uncertainty. Having been burned twice in the last decade, investors are more actively asking for higher returns.

Slower MFP gains. Firms may be responding to worries that the industry is nearing the end of outsized productivity gains. In this connection, MFP growth slowed to a 2.3 percent annual pace over 2016-2019—still impressive, but a sharp step down from a nearly 10 percent pace over 2011-2016. The slowdown likely reflects the maturing and now near universal adoption of fracking technologies.

A look at long-term performance across industries supports the notion that productivity growth in the oil and gas sector will remain lower than in the 2010s. Across successive multiyear periods, there is a marked tendency for industries seeing especially strong MFP growth during one period then experiencing lackluster growth during the next. A slowing in the sector’s MFP growth would sharpen the trade-off between output and capital discipline. Boosting output would then require higher investment outlays, leaving less cash to return to investors.

The 2022:Q1 Dallas Fed survey also asked firms what price would be needed to push the industry into “growth mode.” Some 41 percent of firms said $80-100/barrel would be needed. Another 29 percent cited a price above $100-120/barrel or higher. (The rest said the decision did not depend on prices.) The stronger pickup in extraction activity since Russia’s invasion of Ukraine, with prices staying above $100/barrel, is consistent with this survey response. Notably, similar questions in the third quarter of 2016 and the fourth quarter of 2017 placed growth mode at below $70/barrel. In short, U.S. firms are apparently willing to expand production aggressively only at a much higher price threshold than in the recent past.

A shift to a higher price threshold has global implications. During the 2010s, U.S. firms played a key role in keeping global energy prices low, via their outsized contribution to growth in global gas and energy production. Indeed, the Department of Energy estimates that 75 percent of the increase in global production of liquid fuels from 2010 to 2019 came from higher U.S. production. Slower productivity growth and investors’ demand for higher returns argue against a repeat performance in the years ahead. The result may be a persistently higher floor for global energy prices.

Matthew Higgins is an economic research advisor in International Studies in the Federal Reserve Bank of New York’s Research and Statistics Group.

Thomas Klitgaard is an economic research advisor in International Studies in the Federal Reserve Bank of New York’s Research and Statistics Group.

How to cite this post:
Matthew Higgins and Thomas Klitgaard, “The Disconnect between Productivity and Profits in U.S. Oil and Gas Extraction,” Federal Reserve Bank of New York Liberty Street Economics, August 17, 2022, https://libertystreeteconomics.newyorkfed.org/2022/08/the-disconnect-between-productivity-and-profits-in-u-s-oil-and-gas-extraction/.


Disclaimer
The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author(s).

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Spread & Containment

How bonds work and why everyone is talking about them right now: a finance expert explains

Investor confidence in the UK is at a low, and the bond market has reacted dramatically.

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The Bank of England is buying bonds again. Just as it was about to start selling the debt it had accumulated as part of its last effort to support the economy during the COVID-19 pandemic, the central bank has been forced to announce a new scheme to shore up investor confidence.

The bank’s £65 billion short-term spree aims to address the slump in bond prices caused by investors rushing to sell after the government’s recent mini-budget. This led to a surge in bond yields that hiked borrowing costs for the government and spread to pensions, housing and the general economy. So far, it has had a limited initial impact on the markets.

We asked an expert in finance to explain what’s going on in bond markets.

What is a bond and what is the difference between bond prices and yields?

A bond is essentially a tradeable IOU. It’s a loan that investors make to issuers such as companies or governments (UK government bonds are often called gilts). A bond has a price at which it can be sold and a yield, which is an annual amount the investor receives for holding the bond, a bit like interest on a savings account, and is expressed as a percentage of the current price.

When the price of a bond falls, it signals less demand for the bond because fewer investors want to own it. At the same time, the yield rises, which represents a higher cost of borrowing for companies or governments that issued the bond because this is what they have to pay to investors.

In the days since the government’s mini-budget, yields on 10-year Treasury bonds – which are issued by the UK government – increased from approximately 3.5% to 4.52% – the highest since the 2007-2008 global financial crisis. The expectation of continued increases prompted the recent intervention by the Bank of England.

UK government 10-year bond yields

United Kingdom 10-year bond yield. Investing.com / Tradingview

What causes bond yields to move?

To understand this, it is important to bear in mind that, while people often talk about the interest rate, there are actually a number of rates. This includes the rate at which the central bank lends to commercial banks (the base rate), the rate that banks lend to each other (the interbank rate), the rate that the government borrows at (Treasury yields) and the rate at which households and firms borrow (commercial loans and mortgages).

When the Bank of England changes the base rate, this cascades through all these rates. As such, the Bank of England carefully considers the state of the economy – that is, growth and inflation – when deciding on the base rate.

When an economy is growing, interest rates and bond yields tend to rise. The occurs for several reasons. Investors sell bonds to buy riskier assets with better returns. Firms and households also look to borrow more money in a growing economy, for example, to invest in new machinery or to move home. More demand for borrowing means lenders can charge higher interest on their loans.

Higher inflation often accompanies economic growth because of the increase in demand for goods and services. This tightens supply and causes prices to rise (including wages for labour). The Bank of England, which is mandated by the government to try to keep inflation as close to 2% as possible, will respond to higher inflation by raising base rates, which, as noted, feeds through to the different rates.

Investors will often anticipate the increase in base rates and look to act before it goes up by selling Treasury bonds and buying alternative, higher return, assets. This causes bond yields to rise further. As a result, the Treasury bond yield is often seen as a predictor of future Bank of England base rate changes.

So, if yields are rising, does this mean that investors are expecting future economic growth in the UK?

No, not at the moment. When the government raises money by issuing bonds, it does so over a range of time periods (called maturities), from one day to 30 years. When an economy is expected to grow, the yield on longer-term bonds will be higher than the yield on shorter-term bonds.

This relationship between yields across different maturities is referred to as the term structure or yield curve. An upward sloping yield curve implies a growing economy. At the moment, the UK yield curve is flat, or even downward-sloping across some maturities. My research shows that a falling yield curve is a good predictor of a coming recession.

Yield curve for UK government bonds

Line graph showing downward-sloping yield curve for UK gilts
UK gilts 40-year yield curve. *The curve on the day of the previous MPC meeting is provided as reference point. Bloomberg Finance L.P., Tradeweb and Bank of England calculations

It’s important to remember that these different yields act as a benchmark for commercial lending rates of equivalent lengths. The approximate jump to 4.5% in 2-year and 5-year yields has been reflected in mortgage rates, which is why some lenders have pulled available mortgage deals recently while they reassess the lending rates charged to households.


Read more: Is the UK in a recession? How central banks decide and why it's so hard to call it


But if the UK economy is not expected to perform well, why have bond yields been rising after the chancellor’s mini-budget announcement?

The rising bond yields we are seeing relate to an additional factor: the amount of government debt. The mini-budget introduced tax cuts and increased spending and investors know the government will need to increase borrowing to meet these commitments. Some estimates put potential government borrowing at £190 billion due to this plan.

An increase in the amount a homeowner borrows versus the value of their home (called the loan-to-value) causes the mortgage rate charged to the borrower to rise. Similarly, an increase in the amount of bonds that the government will be looking to sell (the amount it wants to borrow) will push down the price of existing bonds, increasing yields. More importantly, more debt without growth raises the risk level of the UK economy.

Anticipating this, investors triggered a large-scale bond sell-off after the government’s mini-budget announcement. This contributed to the fall in the value of the pound as investors selling UK Treasury bonds bought US bonds instead, essentially swapping pounds for dollars.

So will the Bank of England’s plan work?

The intervention will have a short-term positive impact, which started as soon as it was announced. But the bank is really only buying time. Any ultimate success depends on the government restoring investor confidence in its economic plans.

Unfortunately, rising yields and borrowing costs for the UK economy is the price we are now paying for the government’s recent fiscal announcement.

David McMillan does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.

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Economics

Wyshbox Life Insurance study shows how the pandemic, inflation and looming recession has led to women worrying about their financial future.

Wyshbox Life Insurance study shows how the pandemic, inflation and looming recession has led to women worrying about their financial future.
PR Newswire
MILWAUKEE, Sept. 29, 2022

Through interviews and surveys of over 400 working women between the …

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Wyshbox Life Insurance study shows how the pandemic, inflation and looming recession has led to women worrying about their financial future.

PR Newswire

Through interviews and surveys of over 400 working women between the ages 20-45 years, the numbers aren't good for how women feel about their financial future.

MILWAUKEE, Sept. 29, 2022 /PRNewswire/ -- It's no surprise that women have had to deal with unprecedented volatility over the past few years. The (financially) unprotected sex by Wyshbox Life Insurance includes interviews and surveys of over 400 women and takes a deep dive into how much of a negative financial impact the pandemic, inflation and fears of a potential recession in the future has had on women of different ages and cultural backgrounds. We've discovered that 83% of women surveyed worry about high inflation in the future, which has increased their household expenses and has had a negative effect on their purchasing power. Shockingly, the biggest worry for women of color (35% surveyed) is that their wages are not keeping pace with rising expenses, a worry not shared as strongly by caucasian women.1

New study shows how the pandemic, inflation and looming recession has women worrying about their financial future.

Found on our website at www.wyshbox.com/women, The (financially) unprotected sex white paper not only seeks to understand the emotional and financial burdens and worries of women of different racial backgrounds, but also their employment and childcare struggles when compared to men.

"An eye-opening learning we found was that 30% of caucasian women versus 42% of women of color had to quit their job over the pandemic," says Hetal Karani, Senior Strategist who led the research effort for Wyshbox. Those who had quit the workforce cited pursuing higher education opportunities, limited childcare availability and a lack of alternative schooling options as their main reason to exit the labor market—in addition to not wanting to risk their family's health after being denied remote working options by their employer.1 

Coupled with the importance of a mother's salary and a steep rise in dual income households, we found these learnings particularly troubling. "More than 70% percent of households with children under 18 years rely on the woman's salary, and 40% of moms are the primary breadwinner for the home,"1 added Hetal, "yet our emphasis on the importance of financial planning for the well being of women and their families has remained stagnant"

And when it comes to protecting their future, 70% of mothers said they were worried about what would happen to their families if they passed away.2 So it was no surprise that Wyshbox Life Insurance saw an unprecedented level of women applying for Life Insurance, well above the historical average. Applicants were looking to protect their children and spouse should they lose their salary unexpectedly, cover their mortgages to protect their family from losing their home pay out to a college tuition that they have been saving for.

Read The (Financially) Unprotected Sex white paper for insights and actionable takeaways for not only the insurtech industry, but for anyone looking to understand how women are taking on the new challenges in front of them.

About Wyshbox

Wyshbox life insurance is there to help make sure that life post-you is everything you want it to be. Wyshbox provides term life insurance tailored to everyone's specific needs with policies that can help take care of your family, kids, pets, friends, funeral arrangements, and so much more. It takes less than 10 minutes, is 100% online, and plans start at just $9 per month.

Media Contact:
media@wyshbox.com

Copyright © 2022 Wysh Life and Health Insurance Company
*Disclosures at: www.wyshbox.com/ad-disclosures 

1 Wyshbox Life Insurance. Quantitative Survey "Women during COVID and Recession". 400 participants. August 8, 2022
2 Wyshbox Life Insurance. Quantitative Survey "Thematic Survey". 1200 participants. November 2021

View original content to download multimedia:https://www.prnewswire.com/news-releases/wyshbox-life-insurance-study-shows-how-the-pandemic-inflation-and-looming-recession-has-led-to-women-worrying-about-their-financial-future-301636835.html

SOURCE Wyshbox

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Economics

August data shows UK automotive sector heading for a “cliff-edge” in 2023

With an all-out macroeconomic storm brewing in the UK, the Bank of England (BoE) has been forced to intervene in the tumultuous gilt markets, particularly…

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With an all-out macroeconomic storm brewing in the UK, the Bank of England (BoE) has been forced to intervene in the tumultuous gilt markets, particularly towards the tail end of the yield curve (details of which were reported on Invezz here).

Car manufacturing is a key industry in the UK. Recently, it registered a turnover of roughly £67 billion, provided direct employment to 182,000 people, and a total of nearly 800,000 jobs across the entire automotive supply chain, while contributing to 10% of exports.

Just after midnight GMT, data on fresh car production for the month of August was released by the Society of Motor Manufacturers and Traders Limited (SMMT).

Strong annual growth but monthly decline

Car production in the UK surged 34% year-over-year settling at just under 50,000 units. This marked the fourth consecutive month of positive growth on an annual basis.

However, twelve months ago, production was heavily dampened by a plethora of supply chain bottlenecks, work stoppages on account of the pandemic, and a worldwide shortage of microchips. The August 2021 output of 37,246 units was the lowest recorded August volume since way back in 1956.

Although the improvement in output is a good sign, equally it is on the back of a heavily depressed performance.

Source: SMMT

To place the latest data in its proper context, production is still 45.9% below August 2019 levels of 92,158 units, showing just how far adrift the industry is from the pre-pandemic period.

Since July, production in the sector fell 14%.

The fact that the UK is facing a deep economic malaise becomes even more evident when we look at full-year numbers for 2020 and 2021.

In 2020, total output came in at 920,928 units, while 2021 was even lower at 859,575. The last time that the UK automotive sector produced less than one million cars in a calendar year was 1986.  

Unfortunately, 2022 has seen only 511,106 units produced thus far, a 13.3% decline compared to January to August 2021.

In contrast, the 5-year pre-pandemic average for January to August output from 2014 – 2019 stands well above this mark at 1,030,527 units.

With car manufacturers tending to pass price rises on to consumers, demand was dampened by surging costs of semiconductors, logistics and raw materials.

The SMMT noted,

The sector is now on course to produce fewer than a million cars for the third consecutive year.

Ian Henry, managing director of AutoAnalysis concurred with the SMMT’s analysis,

It is expected that by the end of this year car production will reach 825,000, compared to 850,000 a year ago, but that’s 35% down on 2019 and a whopping 50% on the high figure of 2017.

Sector challenges

Other than the obvious fact that the UK’s economic atmosphere is in hot water, the automotive industry (including component manufacturers) has been struggling to stave off the high energy costs of doing business.

In a survey, 69% of respondents flagged energy costs as a key concern. Estimates suggest that the sector’s collective energy expenditure has gone up by 33% in the last 12 months reaching over £300 million, forcing several operations to become unviable.

Although the government enacted measures to cap the price of energy and ease obstacles to additional production, Mike Hawes, the CEO of SMMT, said,

This is a short-term fix, however, and to avoid a cliff-edge in six months’ time, it must be backed by a full package of measures that will sustain the sector.

Due to the meteoric rise in costs across the automotive supply chain, 13% of respondents were cutting shifts, 9% chose to downsize their workforce and 41% postponed further investments.

Bleak outlook

Uncertainties around Brexit and the EU trade deal are yet to be resolved.

Moreover, the energy crisis is poised to get even more acute unless Russia withdraws from the conflict, or international leaders ease restrictions on Moscow. Last week, I discussed the evolving energy crisis here

With global central banks expected to tighten till at least the end of the year, demand is likely to be squeezed further pressurizing British car manufacturers.

Electric vehicles made up 71% of car exports from the UK in August, but robust growth in the sector looks challenging in the near term, in the absence of widespread charging infrastructure, high electricity prices and globally low consumer confidence.

Although energy subsidies could provide some relief in the immediate future, the industry will remain in dire straits while investments stay low and the shortage in human capital persists, particularly amid the push for EVs.

Given the prevailing macroeconomic environment, and severe market backlash to Truss’s mini-budget (which I discussed in an earlier article), the sector is unlikely to turn the corner any time soon.

The post August data shows UK automotive sector heading for a “cliff-edge” in 2023 appeared first on Invezz.

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