When It Rains, It Pours
Companies and governments grappling with falling oil and gas prices are learning a difficult lesson about procyclicality.
Life is procyclical. Which is another way of saying, when it rains, it pours.
Companies and governments that prospered and felt remarkably confident about their prospects during the recent energy boom are now suffering and have grown remarkably pessimistic. And the changing circumstances compel them to take actions that exacerbate their challenges and cast further doubt on the future.
Consider Oklahoma, the locus of the natural gas boom. Energy-related tax revenues have plummeted in the past few years, and continue to plummet this year. The state lost more than 9,000 jobs between December 2014 and December 2015. As a result, Oklahoma is staring at a deficit for the coming fiscal year of US$1.3 billion, equal to nearly 20 percent of its budget. Because states are forbidden from running deficits, Oklahoma will have to consider big spending cuts (reducing school days, firing employees) and tax increases — actions that will contribute further to the slowdown in the state. In West Texas, where many towns are experiencing the same combination of lower employment and lower tax revenues due to declining oil prices, several towns are facing potential credit downgrades — which will increase borrowing costs and aggravate the financial situation further.
Companies in the oil and gas business face a similar issue. During the boom, many of them took on a lot of debt, hired many people, and made huge investments as energy prices soared. With oil and natural gas prices low, they now face a challenge. In order to raise cash to keep current on debts, they have to sell assets — at a time when prices are low. And the rush to sell into a glutted market can depress prices for assets further, which makes it harder for companies to reap the revenues they need to stay alive.
It’s easy to ascribe these natural components of the boom-and-bust cycle to poor planning and a lack of foresight. But the reality is that, whether you run a company or a state, our systems are governed by a set of incentives and norms that encourage procyclical behavior and discourage countercyclical activity.
What do I mean? Let’s say you run a government. Tax revenues grow rapidly because there’s a sharp rise in employment, spending, and taxes from a certain activity. The prudent, far-sighted thing to do might be to put all the gains in a rainy-day fund, which will serve as ballast at a later time. Most states do, in fact, maintain such funds. (North Dakota channels 30 percent of its oil and gas revenues into the North Dakota Legacy Fund, which functions as a kind of sovereign wealth fund for the state.) But the far more rational response — at least if your goal is to get reelected — is to share the bounty with stakeholders: to cut taxes, to improve services, to invest in infrastructure. And to a degree, this is what governments are supposed to do.
The issue is that these actions effectively set up trouble down the road. Reduce tax rates, and you create a structure guaranteed to produce lower revenues when economic activity declines. Boost spending and you establish a new, higher benchmark on which all future budgets are based. So when the slowdown comes, states are always hit with a double whammy. The system is less able to generate revenues precisely at the same time that expectations and commitments are rising.
Executives at companies face a similar challenge. Let’s say there’s a boom in your core business: oil production. The price of oil soars to $50 a barrel, then $60, and then $80. The core business is providing immense rewards, and shareholders place outsized values on pure plays.
The rational short-term — and expected — response is to increase the dividend, committing the company to a higher level of future payments. Next, you invest more in the highly profitable core business. After all, it’s what you know and it is where the money is. So when oil prices are high, companies get involved in larger, more difficult projects. They’re willing to pay higher prices to access resources, through leases or acquisitions. They borrow money to fund this expansions. Shareholders expect — and reward — this procyclical behavior.
In retrospect, it might be shrewd to engage in countercyclical behavior — to use the gusher of profits to pay down debt, to build reserves in anticipation of a rainy day, or to invest in businesses that are less volatile. But these moves are likely to raise hackles among shareholders and the media. After all, each of them has the potential to reduce profits or cut into the returns of investors. When the economy, or a particular sector, is in expansion mode, procyclical behavior is encouraged and rewarded.
Nobody buys an umbrella when it is 80 degrees and sunny.
The problem is that procyclicality works in reverse, as well. When the boom ends and the stock price falls, the pressure becomes intense to engage in the type of activities that stakeholders don’t like. In the past year, energy companies have been cutting dividends, slashing capital expenditures, and selling off assets at depressed prices. To a degree, these procyclical moves exacerbate the problems: reduced dividends make the stock less attractive; cutting capital expenditures can hurt a company’s future competitive position; selling off assets at fire-sale prices can force companies to record losses.
When it rains, it pours.
Unfortunately, there is no easy way to combat procyclicality. It’s ingrained in the way companies, markets, and governments operate. When things are going well and the climate is favorable, it’s difficult to wrap your mind around the possibility of foul weather. To plan for a bust, you’d have to change the expectations of your stakeholders and the world at large, so that everyone pays attention to long-term forecasts. Otherwise, nobody buys an umbrella when it is 80 degrees and sunny.