Economic Perspectives

Shale as saviour?

Print edition : December 27, 2013

Pump jacks at the Midway Sunset oilfield in California, U.S. Photo: LUCY NICHOLSON/REUTERS

In the Monterey Shale in California, an exploratory well drills for oil using the hydraulic fracturing, or fracking, method, in which large amounts of water, sand and chemicals are injected into shale formations to force hydrocarbon fuels to the surface. Photo: LUCY NICHOLSON/REUTERS

AS the world looks for every sign of robust recovery from a five-year-long recession, investment in and production of shale gas and oil in the United States is being touted as the stimulus that would prove saviour. The financial sector, too, is looking to this real resource for a much-needed boost. For example, Stephen Pagliuca, managing director of the private equity giant Bain Capital LLC, is reported to have said that in the face of threats such as rising interest rates and a large government debt burden, “the salvation of the United States is the big oil and gas boom going on right now”, which he expects will “last a long time”.

The production of shale oil and gas, which was long considered too difficult or too expensive to recover from the rock formations in which they are embedded, has registered a significant rise since 2000. Over a decade ending 2010, shale gas production increased 12-fold to account for a quarter of total U.S. gas production. In a short span of time between 2007 and 2011, shale gas production rose from 1.3 trillion cubic feet to 8 trillion cubic feet. According to projections, that growth is likely to be sustained and even accelerate.

Rising production of oil and gas in the U.S. is reducing that country’s dependence on oil imports. Net imports of oil as a share of domestic consumption have fallen from 60 per cent in 2006 to 45 per cent in 2011. According to the Economic Information Administration (EIA), October 2013 was the first month in 18 years when U.S. crude oil production exceeded imports, with crude oil imports being at their lowest since February 1991. In 2012, the U.S. was a net exporter of liquid fuels and other petroleum and a marginal importer of natural gas. Underlying all of this is the shale and tight oil and gas boom.

Hydrocarbons like oil and gas are formed from organic matter such as dead animals and plants that escape being eaten by scavengers or being oxidised to form water and carbon dioxide and are carried to and sink to the bottom of sea to be converted into “source rock”. As the accumulating sediment subsides below the earth’s crust it becomes a sedimentary basin superimposed by rock formations, which is then, over millions of years, converted into oil or gas at different depths.

The petroleum industry extracts these resources by drilling through the rock formations to the relevant basin from where the oil and gas is released through porous and permeable rocks based on the pressure that has hitherto held them down. But not always is the rock formation, beneath which or in which the oil and gas rest or are embedded, porous and permeable. There are reserves of oil and gas that have over the ages accumulated in rock formations that are not porous and permeable, but are “tight” and, therefore, difficult and costly to retrieve. But developments in technology that combine “hydraulic fracturing” (fracking) and horizontal drilling (which involves drilling down and then turning the drill horizontally to penetrate the rock formation that is to be fractured) have reduced the cost of accessing oil and gas trapped in shale rock formations. High oil prices have helped make the whole process commercially viable.

The problem is that the process of reaching and extracting oil and gas trapped in shale rock formations impacts heavily on the environment. The technology involves combining millions of gallons of water, sand and toxic chemicals and pumping the mixture at high pressure down and then horizontally through the well to reach and fracture the relevant rock layer. The fissures that are created in the shale formation in which the gas is trapped are kept open by the sand so that the gas flows into the well to be retrieved.

There are many outcomes associated with this process. The first is the depletion of water resources, given the exchange of water for gas. The industry and its lobbyists claim that the water used can be retrieved and recycled so that there is no repeated draw on the world’s already scarce water resources. The second is that the toxic chemicals used in fracking can, and have been known to, seep into ground water aquifers, contaminating the clean water that needs to be accessed for drinking and other purposes. Third, the process of fracturing the shale rock formations are known to set off tremors and small earthquakes, which can in earthquake-prone zones have more damaging effects. These should be enough to induce caution when exploiting the opportunity that fracking seems to offer. Not surprisingly, some States in the U.S. and a number of countries have put fracking on hold.

But the strategic benefit that reduced dependence on import of and control over fossil fuels implies has encouraged the Barack Obama administration to back the proliferation of fracking across the U.S. to exploit the second largest reserves of shale oil in the world (after Russia) and fourth largest reserves of shale gas (after China, Argentina and Algeria).

As a result, these unconventional fossil fuels have taken on a new role: that of offering capitalism the next stimulus to growth. There are many routes through which this stimulus is supposed to come. The first is the large investments that are now being made and will be made to exploit this resource, which would spur demand. That demand would consist of the direct demand for metals companies and manufacturers who supply materials and equipment for drilling, as well as the indirect demand generated by the employment and multiplier effects flowing from the process. The second is the impact the expansion of supplies and net exports from the U.S. is expected to have on the prices of oil and gas, which being universal intermediates enter into the costs of most commodities. Downstream industries varying from electricity generation to transportation that are directly dependent on petroleum products will be the most immediate beneficiaries. This could lead to investments that have second- and subsequent-order effects. Based on such speculation a case is being made that shale is likely to be the saviour that pulls the world out of recession, led by the U.S. that has progressed much in exploiting its reserves.

However, there are two major reasons why these great expectations may remain unrealised. To start with, as the U.S. expands production and resorts to exports to the European Union and Asia and countries such as Russia and China decide to push their shale production frontier, it is completely unclear what will happen to natural gas and oil prices. According to the Bureau of Labour Statistics of the U.S. Department of Labour, the Producer Price Index (PPI) for natural gas fell 56.8 per cent between 2007 and 2012, “in response to strong growth in domestic energy production”. It further notes: “The application of horizontal hydraulic fracturing (fracking) to shale rock formations contributed significantly to this increase in supply, as the technique boosted natural gas production yield by more than 25 per cent over this period.”

If gas prices are this responsive to even current rates of increase in production, the shale revolution may bring prices down by so much that shale gas production, which requires digging into impermeable rock formations to release “tight gas”, may turn unviable when compared with extracting other forms of fuels, including other forms of petroleum. The EIA in a 2012 study notes that “increased natural gas supply tends to dampen prices. In turn, lower prices can erode incentive for drilling, which eventually results in decreased production.”

The second obstacle that shale gas production is likely to hit is environmental opposition. The forms that environmental damage can take were noted earlier. The point is there is already evidence of such damage. The biggest challenge is the scramble for water resources that the fracking boom has set off. In December 2011, the conservative Wall Street Journal reported that in South Texas “tensions are rising as companies scramble to lock up water to drill natural-gas and oil wells. All across the State, companies have been on a buying spree, snapping up rights to scarce river water—easily outbidding traditional users such as farmers and cities. Led by ExxonMobil Corp., they also are drilling water wells, three times as many as they did five years ago. They are even tapping into municipal water systems, though parched cities have begun cutting them off.” At that time, fewer than 2,000 oil and gas wells had been drilled over the previous two years in South Texas, but expectations are that that number may climb to as many as 25,000 over the next two decades. That may leave little water for fields and citizens even if recycling is successful.

The water problem does not end here, given the evidence that the chemicals used in fracking are toxic and can seep into drinking water aquifers. Though such evidence is limited and concealed, studies such as one by a group of Colorado endocrinologists reportedly found that “over 75 per cent of the chemicals were harmful for the sensory organs, nearly half could affect the nervous and immune systems and 25 per cent could cause cancer and mutations”. The difficulty is that secrecy with regard to the chemicals used makes it difficult to assess which chemicals and likely effects to scrutinise. Following a model first adopted by Texas, many States in the U.S. have put in place laws that allow drillers (ostensibly on commercial secrecy grounds) to withhold information on the chemicals they use.

Official studies of health effects of fracking are also being delayed. In 2010, Congress mandated the EPA to examine the dangers posed to drinking water by hydraulic fracturing. The comprehensive report, which, however, was to be based on information provided by the gas companies, was to be submitted by 2014. But in 2013, the EPA reportedly declared that the study would be delayed to 2016, by which time a lot of the harm may already be done. Such delays give rise to suspicions of collusion also because there are some signs of official forbearance, as suggested by an Associated Press investigative report that the EPA suppressed the results of a study by Colorado School of Mines geologist Geoffrey Thyne that linked methane contamination of groundwater in Weatherford, Texas, to hydraulic fracturing (“EPA changed course after oil company protested”, January 16, 2013).

Finally, there is the danger of tremors and earthquakes, with studies in Oklahoma and Arkansas, for example, finding some evidence linking increased earthquake incidence to neighbourhood fracking. Given all this evidence, it is not surprising that some States in the U.S. and Canada have put temporary or long-term restraints or moratoria on fracking. As the evidence mounts and the realisation that costs may exceed benefits triggers stronger opposition, the boom could come to an end, even if economic factors do not cut it off. So betting on shale to deliver the long-awaited recovery may be premature, even if not completely misplaced.