Frac-Onomics: Why Fracking Makes Little Economic Sense

Frac-Onomics: Why Fracking Makes Little Economic Sense

Jay Warmke

In 1954, Lewis Strauss, then chairman of U.S. Atomic Energy Commission, famously predicted that "Our children will enjoy in their homes electrical energy too cheap to meter ... ”  Of course he also (in the same speech) predicted that world hunger would disappear and that we would find a cure for aging. Not surprisingly, folks didn't pay much attention. 

Then in 1964, President Lyndon Johnson announced a major “breakthrough” in nuclear energy. It seemed, due to this breakthrough, that Strauss' vision of a nuclear-powered world was just around the corner. The fact that there had been no breakthrough did not stop the press (around the globe) from reporting this “fact”—and as a result, orders of nuclear power plants surged. 

Just the “idea” of an abundant supply of low-cost fuel was enough.  The fact that the idea was a myth, would not affect governmental decision making for another decade or so.

Now, fast forward to 2011. Amid tremendous fanfare, the natural gas industry has announced the “discovery” of vast, enormous, huge, unlimited gas deposits located in the Northeastern U.S., locked in the Marcellus and Utica shale deposits. With the advent of hydraulic fracturing and horizontal drilling techniques—it  will now be possible to tap these vast resources, effectively doubling our nation's natural gas reserves.

As a result of these announcements, state legislatures across the region have moved quickly to eliminate regulations and barriers that might otherwise delay access to this energy resource. State parks have been opened to allow drilling. Community colleges rush to provide training to support this new and expanding “career path.” 

As with nuclear power, it may be decades before we come to understand if this is truly a “breakthrough,” or simply another announcement of a breakthrough that wasn't.

How much gas is there, anyway?

In August of 2011, the U.S. Geological Survey issued a report where they lowered previous estimates of recoverable natural gas located in the Marcellus shale deposits from 410 trillion cubic feet, to 84 trillion cubic feet—a reduction of 80 percent of the earlier estimate that caused all the excitement. 

Now, 84 trillion cubic feet is still a lot of gas, but many geologists have since begun to express doubts about even these projections. They cite the fact that the methods of extracting the gas (hydraulic fracturing and horizontal drilling) are relatively new and untested. They also note that wells of this type seem (where they have been used) to produce for only a very short period of time.

In fact, industry experts estimate that output from fractured wells drops by 81 percent after just two years of production—a much faster rate of decline than is seen in traditional natural gas wells.

Even internal U.S. Energy Information Administration documents released by the New York Times indicated that officials within the government were concerned by the “irrational exuberance” of the gas industry regarding these deposits. They note that the profitability projected by the well fields reflect those found in only the most productive wells, and that the industry is using “overly optimistic models” for their projections.

Noted oil-industry geologist Kenneth Deffeyes, in his book Beyond Oil, observed that naturally fractured shale gas deposits have been a source of natural gas since the early 1800s. These are not new sources. But, he argues, that the very nature of the rock makes it a much less efficient storage device of natural gas than, say, sandstone. This is why they have not been widely developed before now.

Given the stone's inherent structural limitations, Deffeyes states simply that “fractured shales are not a candidate for solving a major portion of our energy needs."

How much does it cost to get at the stuff?

Those who advocate hydraulic fracturing as the future of natural gas will face further problems. 

The international financial services company Credit Suisse conducted a detailed study to find just how much it costs to produce natural gas in North America. They found that production costs have more than doubled over the past decade (still looking primarily at “conventional” sources), topping $8 per MMBtu (million British Thermal Units of energy) in 2008.   

At the same time, the natural gas industry has argued that recent “innovations” have dramatically reduced the cost of getting gas out of the ground. But what has been innovative, it appears, is their method of accounting. 

When the government relaxed rules stating that gas reserves no longer needed to be independently verified—most gas producers instantly doubled their stated reserves. On paper it appeared that the cost of getting the gas was cut in half.  In reality (as Credit Suisse found), the costs (that were actually increasing) just appeared to be lower as they were spread over larger (and yet to be seen) estimated amounts of natural gas that might one day (fingers crossed) be extracted from each well.

Another study, conducted by the University of Pittsburgh in 2011, found that gas obtained from wells that use hydraulic fracturing costs approximately 90 percent more than gas from more traditional wells. Other industry analysts simply state that the cost from these “unconventional” sources will add a dollar or two per MMBtu to production costs. 

The Pitt study found that the average cost of developing a well that utilized hydraulic fracturing was approximately $7.6 million in direct costs (others place that cost as high as $10.5 million per well)—as compared with $4 to $5 million for more traditional wells. 

If these non-industry numbers are to be believed, it appears that the cost of producing natural gas from a new well using hydraulic fracturing will average around $9-$10 per MMBtu. Yet, for the past two years the wellhead price of natural gas (the price producers get) has hovered below $4 per MMBtu.

So if the price of natural gas is only $4 and the industry needs to sell the product for over $10 to make any money—how can this be? Aren't they loosing $6 on every sale?  Won't they go out of business?

Ah, if only business were that logical. 

Not all Gas is created Equal

First, it is important to understand that the $10 plus price point is for every NEW (marginal) bit of gas produced. Existing wells that were constructed when costs were much less are still producing relatively cheap natural gas. Some older well fields are still producing at costs less than $1 per MMBtu. Others are producing in the $2-$3 range.  So those operations are still profitable, even at $4 natural gas prices. 

In for a Penny, in for a Pound

Another complicating factor is that gas field speculators may already have spent a great deal (sunk costs) on a well field back when prices seemed to justify the investment. The cost of lease rights, geological surveys, infrastructure development (such as roads and rigs) and the like may already have been spent. So looking at the situation today, the investor is faced with a couple of choices. 

She can abandon the project and simply write off her investment (which might be substantial)—or go ahead and finish the project. If she only needs to invest another $3.50 per MMBtu to begin producing, then it may make sense (from today's perspective) to continue even if she has to sell the gas at $4 per MMBtu (of course, hoping the price will go up over time).

I'll Gladly Pay you Tuesday for a Hamburger Today:

Natural gas is a commodity, and as such, is bought and sold in future's markets (such as Henry's Hub). 

Within these markets, you could, for example, purchase gas that you intend to use right away (called the “spot market").  This would be similar to buying a loaf of bread at the grocery store. They tell you the price, you pay it—then take the bread home and eat it.

Or you might try to lock in a price for some date in the future. For example, currently the price of natural gas is under $4 per MMBtu. If you feel that price is going to go up, you might contract with a supplier to buy his gas in 2014.  You haggle a bit (because at this point you are both just guessing as to what the “spot” price will be in two years). Perhaps you settle on a price of $5.50 per MMBtu. If the price in two years is higher than that—you win (and make some money). If it is lower, you end up paying a higher price for the gas than you would have if you had waited and paid the spot market price.

Large consumers and suppliers of natural gas use this system to protect themselves against wild swings in prices (“hedging” their bets, so to speak). For example, a steel mill that consumes vast amounts of natural gas may be willing to pay a bit of a premium to lock in costs for several years—because rapid price increase might put them out of business (and besides, it makes accounting so much easier).

Sellers may also want to lock in future prices. Back during the summer of 2008, the price of natural gas approached $12 per MMBtu. A smart supplier at that time might have signed contracts for delivery in 2011 at a price of, say $8 per MMBtu. The buyer may have felt she was getting a great deal, locking in a price at two-thirds the then current market price. 

The seller delivers the contract (the gas) in 2011 and is paid $8 per MMBtu at a time when the spot price is only $4 per MMBtu. Well done you. And this was in fact done (or variations of this dance) many times over. But these contracts last only a few years (nobody is willing to speculate too far into the future), so these lucrative futures contracts are expiring. 

So a well that was producing at a breakeven cost of $7 per MMBtu might still be profitable (if the owner had locked in a good futures contract), even though the spot market price is well below the breakeven cost. But now that the futures contract has been filled—the well may no longer be profitable.

Dare I say it?  The Gas Bubble

As we have seen recently with the Internet Bubble and the Housing Bubble—irrational exuberance that is not based on sound economics leads, eventually, to some pretty ugly outcomes. But trying to convince someone who is completely caught up in the moment is (at the risk of another pun)—like shouting down a well. 

But clearly, if you are really losing $4 to $6 on every sale of natural gas—in the long term, you simply cannot sustain that business (and no, you can't make it up in volume). So, what will be the result?

Well, traditionally, gas companies have simply shut down wells until the price rises to profitable levels. And we may see some of this happening. However, much of the current stock value of these companies are tied up in their rosy projections. Cutting production may dim their appeal and nobody whose quarterly bonus is tied to stock performance wants to see that. So, production may stay strong until the economics force it to collapse under its own weight. 

Also, at the moment many large oil companies have determined that natural gas is the fossil fuel of the future. They are investing literally billions of dollars in this “new” industry—so may be willing to take a loss ... for a while.

Inevitably, we will see a dramatic rise in gas prices. If prices rise once again to the $12 per MMBtu level last seen four years ago—then, problem solved (for those producing gas through hydraulic fracturing).  Except ... is it really?

Enter, Renewables

Natural gas does not live in a vacuum. 

In recent years, the cost of renewable energy has decreased dramatically. In 2010 the average cost of a photovoltaic (PV) installation dropped 30 percent. In 2011 it did it again. What was once a high-cost energy alternative is becoming increasingly affordable. Today, for the first time, it is cheaper in much of the nation to install solar panels on your home than to continue to pay the retail cost of electricity.

Oil billionaire T. Boone Pickens famously (over the past several years) first announced plans for a huge wind energy farm in Texas—then dropped those plans when natural gas prices plummeted. He stated before a Senate hearing that his wind energy project was simply uneconomical when natural gas cost only $4 per MMBtu. But when the price rises to $6 per MMBtu, he stated—then wind energy becomes the low cost alternative. 

Should natural gas prices rise—at $10 per MMBtu (the price at which new hydraulic fracturing wells become economic), natural gas becomes a very expensive energy alternative.  Over the long haul—will people continue to use it?

In Summary

So the U.S. natural gas industry is faced with some difficult alternatives and an uncertain future. Traditional supplies are rapidly running out. Many industry experts point to data that indicates that as much as 70 percent of the conventional U.S. natural gas reserves have already been exhausted. So the industry's only alternative is to tap into the unconventional (and vast) reserves such as those found in shale deposits.

However, this unconventional gas is difficult and expensive to recover. So in order for it to be profitable, gas producers must either reduce costs or increase the price for their product. 

Reducing the cost of production (in reality, not on paper) is difficult given the nature of how this gas must be extracted and will likely be made even more difficult as increasing environmental regulations and restrictions are put in place. 

And increasing costs (which will be the inevitable consequence of a declining supply) will make natural gas less and less appealing to consumers who will turn to lower cost alternatives (such as wind and solar).   awmakers might want to take a closer look at the economics of the industry before betting our energy future on shale gas.

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