The Frack Farce

The UK government's decision tohas been welcomed by the oil industry, and widely lambasted by environmental campaigners. But to a large extent the debate about the potential of shale gas in this country has completely missed the point.

The UK government's decision to resume fracking has been welcomed by the oil industry, and widely lambasted by environmental campaigners. But to a large extent the debate about the potential of shale gas in this country has completely missed the point.

While Prime Minister David Cameron this week lauded the economic potential of the "shale gas revolution", critics insist that fracking will escalate fossil fuel emissions and create intractable environmental problems.

Yet neither have acknowledged a far deeper, and arguably more fundamental question: do the economics of shale gas really add up?

A New York Times investigation last year found that state geologists, industry lawyers and market analysts "privately" questioned "whether companies are intentionally, and even illegally, overstating the productivity of their wells and the size of their reserves." According to the Times, "the gas may not be as easy and cheap to extract from shale formations deep underground as the companies are saying, according to hundreds of industry e-mails and internal documents and an analysis of data from thousands of wells."

Early this year, US energy consultants Ruud Weijermars and Crispian McCredie, writing in the flagship British energy industry journalPetroleum Review, noted a strong "basis for reasonable doubts about the reliability and durability of US shale gas reserves" which have been "inflated" under new Security and Exchange Commission (SEC) rules introduced in 2009. The new rules allow gas companies to claim reserve sizes without any independent third party audit.

The overestimation of reserve sizes is being used to obscure the dodgy economics of fracking. The first problem is production rates, which start high, but fall fast - by as much as 60 to 90 percent within the first year.

The rapid decline rates have made shale gas distinctly unprofitable. As production declines, operators are forced to increasingly drill new wells to sustain production levels and service debt. Rocketing production at inception, combined with the economic slowdown, has driven US natural gas prices from about $7-$8 per million cubic feet in 2008 down to less than $3 per million cubic feet today.

"The economics of fracking are horrid", reports US financial journalist Wolf Richter in Business Insider. "Drilling is destroying capital at an astonishing rate, and drillers are left with a mountain of debt just when decline rates are starting to wreak their havoc."

This year has seen some of the biggest energy companies suffer due to the bubble economics of the shale gas boom.

Just four months ago, Exxon's CEO, Rex Tillerson, complained that the lower prices due to the US natural gas glut, while reducing energy costs for consumers, were depressing prices and, hence, often insufficient to cover production costs resulting in dramatically decreased profits. Although in shareholder and annual meetings Exxon had officially insisted it was not losing money on gas, Tillerson privately told a meeting at the Council on Foreign Relations: "We are all losing our shirts today. We're making no money. It's all in the red."

Around the same time, the BG Group was forced "to take a $1.3bn writedown in its US natural gas assets" due to the gas supply glut, "leading to a sharp fall in quarterly and interim profits." By November, Dow Jones reported ongoing "negative effects in their earnings", underscoring "how disruptive the shale boom of the past few years has been to the sector." Similarly, another company, Royal Dutch Shell, saw its earnings fall for the third consecutive quarter by "24% on the year", while the average price Shell received for its North American gas fell 38 per cent.

Even Chesapeake Energy - billed as the country's shale pioneer - in September found itself in a crisis, forcing it to sell assets to meet its obligations. "Staggering under high debt," reported the Washington Post, Chesapeake said "it would sell $6.9 billion of gas fields and pipelines - another step in shrinking the company whose brash chief executive had made it a leader in the country's shale gas revolution." The sale was forced by a "combination of low natural gas prices and excessive borrowing."

How has this been allowed to happen? The Financial Times' John Dizard points out that shale gas producers have spent "two, three, four, and even five times their operating cash flow to fund their land, drilling, and completion programmes." To sustain this "deficit financing", too much money "was borrowed, on complex and demanding terms. Wall Street should have provided reality checks to the shale gas people; instead, they just provided cashier's cheques with lots of zeroes at the end." But the bubble will continue growing due to increasing US dependency on gas-fired power. "Given the steep decline rates of shale gas wells, compared to conventional wells, drilling will have to continue. Prices will have to adjust upwards, a lot, to cover not only past debts but realistic costs of production."

So the shale gas revolution will not usher in a new heyday of clean, cheap oil - but it will accelerate debt instabilities in the oil industry that might blow up in our faces.

The worst-case scenario is that several large oil companies find themselves facing financial distress simultaneously. If that happens, according to Arthur Berman - a 32-year petroleum geologist who worked with Amoco (prior to its merger with BP) - "you may have a couple of big bankruptcies or takeovers and everybody pulls back, all the money evaporates, all the capital goes away."

Unfortunately, in the wake of an overwhelmingly successful industry PR offensive, such questions have been largely overlooked.

The upshot is simple: Rather than ushering in a new wave of lasting prosperity, the eventual consequence of the gas glut could well be an unsustainable shale bubble, fueling a temporary economic recovery that masks deeper structural instabilities. When the bubble bursts under the weight of its own debt obligations, it could generate a supply collapse and price spike with serious economic consequences.


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