Mystery and high stakes often go together, as is the case with fracking — the process of using high pressure to extract oil and gas from shale rocks buried deep under the earth’s surface. Fracking companies are hot destinations for investors chasing yields and growth industries, especially private equity companies, in part because of the large appetite the capital intensive industry has for debt. However, several warning signs suggest the fracking industry not only may fall short of investor expectations, but also could actually help to precipitate the next financial crisis.

Bethany McLean, a contributing editor at Vanity Fair magazine, explores those fears in her newly published book, Saudi America: The Truth About Fracking and How It’s Changing the World. She delved into those issues also in a recent op-ed article in The New York Times titled, “The Next Financial Crisis Lurks Underground.”

The International Energy Agency earlier this year captured the significance of the U.S. shale industry in a report. “Global oil production capacity is forecast to grow to reach 107 million barrels per day by 2023,” it noted. “Thanks to the shale revolution, the United States leads the picture. Growth is led by the Permian Basin [in Texas], where output is expected to double by 2023.”

“Fracking is a business built on attracting ever-more gigantic amounts of capital investment, while promises of huge returns have yet to bear out,” says an introduction to McLean’s book. In fact, North American exploration and production companies saw their net debt balloon from $50 billion in 2005 to nearly $200 billion by 2015, according to a recent research paper by Amir Azar, fellow at Columbia University’s Center on Global Energy Policy.

Beyond the debt overhang, the fracking industry’s fortunes directly impact oil prices and the rest of the economy, while also being a significant job creator, according to McLean and Jyoti Thottam, The New York Times opinion editor for business and economics. McLean and Thottam drew parallels between the fracking industry’s lofty projections and the Enron scandal of 2001, which both of them had covered extensively as reporters. McLean warned that “at some point, investors want to see real profits and real returns,” while Thottam called for fracking industry watchers to look for early signs of danger. (McLean and Thottam discussed the fracking industry’s fortunes on the Knowledge@Wharton radio show on SiriusXM. Listen to the podcast at the top of this page.)

McLean said she wrote the book because she was “struck by a dichotomy or a conundrum” in which fracking is changing the world. It has enabled the U.S. to race past Russia and Saudi Arabia to become the world’s largest oil producer since the 1970s, “and yet this industry doesn’t make money…. It’s on much shakier financial footing than most people realize.” Thottam noted that the energy industry underpins many other large parts of the economy and is also a big source of jobs. “Anything that raises questions about that is important to consider.”

“[The fracking] industry doesn’t make money. It’s on much shakier financial footing than most people realize.” –Bethany McLean

Contours of a Crisis

Opinion is divided on whether the fracking industry will find that debt servicing is too much to bear. The bulls in the industry point to technological improvements, such as those used in the Permian Basin, as strengthening the financial foundation of the industry, McLean noted. “Others are not so sure, and I felt a little bit unable to resolve that debate. Everybody who has tried to predict the future of fracking thus far has been wrong.”

McLean identified “three major impacts” that may hold the seeds for a potential crisis in the fracking industry. The first is a debt buildup that she sees as being directly linked to the last financial crisis. After the last financial crisis, the Federal Reserve cut interest rates to help the economic recovery, and that enabled the capital intensive fracking industry to raise “massive sums of capital.”

The second impact McLean identified is that as pension funds were no longer able to earn a desirable rate of return on fixed-income instruments, they turned to private equity firms and hedge funds that invested in debt, which in turn provided more capital to the fracking industry. In fact, private equity investors have funded a third of all the investments in the U.S. fracking industry, she said. The third factor is that the fracking industry has attracted significant interest in the public capital markets as a high-growth industry relative to other industries. Those growth expectations ignore the possibility that the profits investors expect might not exist “in a more rational economic environment.”

Thottam agreed that while it could be argued that the Fed was justified in its low-interest rate policy after the financial crisis, those rates would rise eventually. “Essentially, what Bethany lays out is that we’ve gotten used to this American economy that’s built on cheap oil,” she said. “Fracking, which is now a huge part of cheap oil, is built on cheap money, and we don’t know how long that era is going to last.”

Both Fragile and Resilient

While the U.S. fracking industry has its fragilities, it is also resilient in many respects, McLean pointed out. “Fracking is fragile because it’s an industry that’s dependent on the price of a barrel of oil.” And that price has fallen from about $100 to $70.

The U.S. fracking industry is also vulnerable to the actions of other global oil producers. For example, Saudi Arabia increased oil production in 2014 and caused prices to fall to levels that would be nonviable for shale oil producers. “Many people saw this as an attempt to kill U.S. fracking companies by pushing the price of a barrel of oil so low that their already nonexistent profits would become even worse,” McLean said.

The impact of that price fall was severe over the past four years. “About 150 U.S. fracking companies went bust, and production skidded by a million barrels [a day] over a span of time,” McLean noted. That latter figure is significant, considering that the industry is approaching a production level of about 7.5 million barrels per day, according to a report citing the U.S. Energy Information Administration. The law firm Haynes and Boone tracked 167 bankruptcies in the industry since 2015.

Yet, the fracking industry rode out that downtrend and showed that it was indeed resilient. “It looked like this was the final gasp of this industry. It wasn’t,” said McLean. “People who are bullish on the industry will [point to] how resilient it was. And that’s true.” New technology has helped extract petroleum trapped deep underground in shale rocks: Areas that once were seen as nearing the end of their production life cycle have become “incredibly prolific,” such as the Permian Basin in Texas. “People now say Texas … may be the third-largest oil producer in the world.”

“The most important element in the resilience of fracking is that the capital hasn’t gone away.” –Bethany McLean

Technology is also making it cheaper to extract oil, “and there’s an argument that’s going to reshape the financial firmament of the industry,” McLean said. Above all, investors still throng the industry. “The most important element in the resilience of fracking is that the capital hasn’t gone away. Interest rates are still very low, and there’s plenty of money in the form of pension funds and other giant pools of capital sloshing around looking for a place to invest, and that has kept the capital flowing into the fracking industry.”

A Tale of Two Extremes

McLean talked also of two extreme scenarios of winners and losers that divide the bulls and bears in the fracking industry. At one end is Aubrey McClendon, who was CEO of the Oklahoma City-based Chesapeake Energy, once an industry trailblazer. He died in 2016 in a car crash, a day after a federal court indicted him over accusations that he rigged bids for oil and natural gas leases.

“McClendon was one of those larger-than-life characters that comes along every so often in the business world and makes that old adage that ‘truth is stranger than fiction’ ring true,” McLean said. “He was a CEO who was as fearless as he was reckless, and really pioneered the capital-raising in this industry, and went around the world as an evangelist for the U.S. shale industry raising money.”

McClendon found himself on the defensive even when Chesapeake was profitable. “Just when we need large-scale players to step up and invest in the kind of project to create the energy the world needs, it becomes a crime to make money in the industry,” McClendon said at a Wharton Economic Summit panel discussion in New York City in 2006. Chesapeake closed that year with net income of $1.19 billion on revenues of $7.3 billion.

But excessive debt proved to be Chesapeake’s undoing. “Vulture funds descended, buying the debt for less than 50 cents on the dollar…,” McLean noted in her New York Times op-ed article.

At the other end of the spectrum is EOG Resources of Houston, Tex., “known as the Apple of shale,” said McLean. EOG was spun off from Enron back before that company’s infamous bankruptcy, but is seen as a winner in the shale/natural gas industry. “Since weathering the oil bust, EOG has focused on so-called premium wells, which earn a minimum of 30% profit returns after taxes even with oil prices at $40 a barrel,” according to a recent Houston Chronicle report.

“EOG is admired for being very cost-conscious, very disciplined and very focused on returns to investors,” said McLean. “And so it’s unclear which one – [Chesapeake or EOG] – will be the model for the industry going forward.”

The Spillover Effects

The future of the U.S. fracking industry is important not only for investors, but also for the entire economy in terms of how it impacts the price of energy sources for industries and gasoline at the retail pump for drivers. The industry is also a big provider of jobs, especially in Texas and North Dakota, McLean said. “Any failures would have huge economic reverberations both locally and nationally.”

While no safeguards could be imposed to protect the health of the fracking industry, there is increasing “pressure from investors to force companies to be more profitable,” Mclean said. One open question is: How much shale oil does a company need to produce to be profitable? The answer could “pose a risk to all of us [who are] chest-beating about U.S. energy independence or even energy dominance.”

Those concerns were why McLean said she wrote the book. “Part of the point in writing my book was just to make people aware that as we trump at American energy independence, let’s think about some of the foundation of this [industry] and how insecure it actually is, so that we’re also planning for the future in different ways.”

“It’s key to start looking around those places where you know there is danger lurking, and you’re just not sure what [that danger] is, or what it looks like.” –Jyoti Thottam

Thottam said she was concerned about the close ties between the fracking industry and the capital markets. The industry is cyclical, and it is important to track it closely in order to prepare for a crisis. “It’s key to start looking around those places where you know there is danger lurking, and you’re just not sure what [that danger] is, or what it looks like.”

Déjà vu: Enron

McLean saw parallels between the fracking industry and the Enron scandal in that both feature larger-than-life characters, and disconnects between claims the companies make and their financial statements. “When you look at oil companies’ presentations, there’s something that doesn’t make sense because they show their investors these beautiful investor decks with gorgeous slides indicating that they will produce an 80% or 60% internal rate of return. And then you go to the corporate level and you see that the company isn’t making money, and you wonder what happened between point A and point B.”

Although the magnitude of the fraud at Enron was hidden in the years before the scandal broke, “you could see that there were problems on the surface,” said McLean. “You can see that in this case, too – the fact that the industry doesn’t make money, and doesn’t produce free cash flow, is obvious to anybody who looks at financial statements.” For example, just five of the top 20 fracking companies generated more cash than they spent the first quarter of 2013, McLean wrote in her New York Times op-ed, citing a Wall Street Journal article of May 2018.

Oil industry executives, however, argue they are delivering what investors want. “Investors have wanted to see growth in production at all costs, and so that’s what companies have delivered,” McLean said. “Part of this has also been companies trying to meet the pressure from Wall Street as well as companies compensating their executives based on production growth.”

McLean drew parallels also to the dot-com bubble of the 1990s and saw the day of reckoning not too far ahead for fracking companies. During the dotcom bubble, companies were valued on “eyeballs,” or the number of people looking at their sites. “In the absence of traditional measures of valuing a company — like profits and cash flow — people turned to non-traditional measures.”

In much the same way, investors are valuing fracking companies on non-traditional metrics, such as “a multiple of the acreage they own, or on the basis their production growth, rather than looking at their cash flow or their profits.” However, “non-traditional measures of valuation only last until they don’t.” At some point, investors will expect returns. “Otherwise, why are they putting their money into this industry?”

Thottam said that while close scrutiny of the fracking industry is important “for people who care about fracking,” there are others who are concerned about its environmental impact or view it as a source of jobs and economic growth. McLean said many environmentalists have shown interest in the red flags in her book because they are “curious about the financial side of the business and don’t know it as well.”