Is Fracking Bad for Drillers and Investors?

A recent feature at the anti-fossil-fuel Desmog Blog reported the “stunning admission” of a former shale CEO that fracking was a fool’s errand for industry. “The shale gas revolution has frankly been an unmitigated disaster for any buy-and-hold investor in the shale gas industry with very few limited exceptions,” stated Steve Schlotterbeck, formerly of EQT. “In fact, I’m not aware of another case of a disruptive technological change that has done so much harm to the industry that created the change.”

He closed: “The technological advancements developed by the industry have been the weapon of its own suicide.”

Suicide, as in the end of the supply-driven boom? Is a large drop-off ahead for today’s U.S. record oil production of 12.2 million barrels per day, a 12 percent jump from one year ago? Same for natural gas, which is also in a technologically-driven production boom?

Schlotterbeck’s chart of eight companies left out some of the big winners, such as EOG Resources, and included his own company that he left in poor shape. Obviously, there are losers, not only winners, in a market economy, and over-optimism and overexpansion exact a penalty. Creative destruction, after all, ensures that consumers come first, unlike crony capitalism where producers do.

Peak Oil, Peak Gas Not

Schlotterbeck’s lament is “old song, latest verse.” From the late 1920s through the early 1970s (excepting during World War II), a “crisis” of U.S. overproduction resulted in mandatory output cuts (called market-demand proration) in many oil states, as well as federal tariffs and quotas to block oil imports.

Federal price controls, as well as OPEC production cuts, changed that in the 1970s, but deregulation in the early 1980s brought back a buyers’ market. The halving of oil prices in 1986 witnessed new calls for oil tariffs, but free-market reliance brought resource adjustments that have made the industry sustainable, although cyclical, ever since.

Natural gas, too, price-regulated, experienced shortages in the 1970s. But a “natural gas bubble” in the 1980s and 1990s inspired more complaint and calls for government intervention.

Enron CEO Ken Lay, a Ph.D. economist no less, accused the major oil companies of “economically irrational behavior” for selling their natural gas “below cost” at Daniel Yergin’s annual CERA conference in 1991. Another company executive complained that buyers were a lot smarter than sellers. Lay’s fuss was about wellhead gas selling for $1.80/MMBtu, the lowest price since 1976, adjusting for inflation.

That 1991 price equates to $3.35/MMBtu today, which is 40 percent above the market price today. It is all relative, and technology rules—driving costs relative to selling prices.

Do not be fooled. Too “much” or “little” production is part of a self-correcting process, with price signals and profit/loss educating market participants going forward. And far from helpless, producers for decades have hedged forward to lock-in revenue in the face of uncertain spot prices. Entrepreneurial self-help, not government this-or-that, is the way of the true market.

A Caveat

In her monograph, Saudi America (2018), Bethany McLean interpreted the shale revolution as a contrived boom, the result of artificially low interest rates. “If it weren’t for historically low-interest rates, it’s not clear there would even have been a boom,” she writes. Echoing Steve Schlotterbeck (above), she imagines much less production having resulted if drilling was limited to companies’ cash flow, not speculative capital fueled by low-interest rates.

There is some truth to McLean’s analysis, although her conclusion is very overstated.

Undoubtedly, the Federal Reserve’s expansionary monetary policy in the wake of the 2008 financial crisis provided more capital than a free-market monetary regime would have, resulting in more oil and gas drilling and debt than otherwise would have been the case. To this extent, a buyers’ market was falsely incentivized, leading to producer distress, per Schlotterbeck.

Still, there is the entrepreneurial error of focusing too much on supply and not on lower prices from that supply. Examples abound of oil producers making a discovery, borrowing money to drill-up the field, and going insolvent when prices broke. And Exxon Mobil’s $41 billion (over)purchase of XTO in 2010 was the beginning of that storied company’s decline from the top.

New technology lowering finding costs is the ultimate driver of a U.S. that is awash in oil and gas. Necessity being the mother of invention, low selling prices will lead not to a sizeable industry contraction but to new-generation technologies to allow the best companies to persist and thrive in low-price environs.

Conclusion

Resourceship has been the consumer’s best friend since the dawn of the oil and gas industry. All the while, industry participants in a buyer’s market (the norm) have complained about financial distress and, too often, resorted to cronyism with state and federal governments.

Thankfully, legalization of oil exports from the United States, as well as burgeoning LNG (liquefied natural gas) exports, have created new markets to absorb record production. Expect a continuing buyer’s market in the months, years, and decades ahead under free-market energy policy, part of President Trump’s theme of energy dominance. Expect far worse from anti-energy, keep-it-in-the-ground obstructionism.

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