We’ve been big fans of fracking here at MoneyWeek for some time.
We’re excited how the fracking boom has cut energy prices in the US. And we think investors in UK fracking projects may make big profits in the future.
But it’s always worth looking at all sides of an argument. Fracking is a controversial topic – and not just because of the environmental issues. There are plenty of unknowns on the investment side too, and it’s worth being aware of them.
So in this article, I’m going to look at nine potential problems that might reduce returns for investors, or possibly mean investors don’t make any money at all. They’re all factors we’ll be watching closely – and we think you should be aware of them too.
1. Wells don’t last long
Fracking technology is used to extract oil and gas from ‘tight rock’ where conventional drilling techniques don’t work. That’s great – but the trouble is that production from these wells starts to decline very quickly.
After a year, production typically falls by around 40%. After four years, the decline is roughly 90%. To maintain production, you have to constantly drill new wells in the same area. This means that optimistic forecasts of ‘cheap energy forever’ might be too hopeful – and it also means that companies need to stay on the move to maintain production levels.
2. Fracking isn’t cheap
Fracking requires more labour and more investment than conventional drilling methods. That drives up the cost. Improving technology may bring down this cost per well, but it probably won’t reduce the cost per barrel of oil. That’s because energy companies will drill the best prospects first.
3. Alternative energy could get cheaper
The cost of solar power has fallen by 60% over the last two years, and I expect further declines to come. We may see a similar thing happen with wind power. If it falls fast enough and the technology keeps improving, that would threaten the viability of all fossil fuel energy sources.
4. Oil price may fall
Cheaper energy from renewable sources is just one reason why we shouldn’t assume that the oil price will always stay at $80 a barrel or more. As the veteran value investor, GMO’s Jeremy Grantham, points out, we may have been focusing on the wrong kind of ‘peak oil’.
For many years, pundits have fretted that the global oil production would inevitably fall because the supply of easily accessible oil would start to run out. According to this theory, we’d soon reach ‘peak oil’ – the year when global oil production reached its highest ever level, followed by a long-term decline.
Grantham, however, suggests that ‘peak oil’ may be about demand rather than supply. As alternative energy sources become more widely used, and energy efficiency increases, demand for oil and gas may fall. That could lead to a lower oil price. And if the price falls far enough, fracking may become uneconomic.
Let’s be clear, Grantham is no bearded, sandal-wearing leftie. He’s a successful, respected investor and I think he makes an interesting point. As a Saudi Arabian oil minister once said, the stone age didn’t end because we ran out of stones. Ideally, the oil age would end in the same way – because we found something better.
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5. Oil exploration is always risky
In the UK, fracking is still at the exploration and development stage. We know there’s plenty of shale oil and gas in the UK. But we can’t be sure that any of it can be extracted in a commercially viable manner.
Investors need to understand that oil exploration is always risky whether you’re looking for conventional oil or shale oil and gas. Over the years I’ve invested in several conventional oil exploration companies and seen share prices soar as excitement gets close to euphoria. Then the company announces that it’s drilled a couple of ‘dusters’ and the euphoria quickly turns to despair.
My experience isn’t unusual. Disappointing drilling results happen all the time.
6. A cautionary tale from Poland
Two years ago there was a lot of excitement about prospects for shale energy in Poland. But then the excitement tailed off.
First off, the Polish government slashed its estimate of total shale reserves in the country. Then ExxonMobil, Conoco Phillips, Marathon Oil and Talisman Energy all shut down or sold their shale gas operations in Poland. These pull-outs were driven by concerns about costs as well as disappointing drilling results.
Admittedly, Aim-listed San Leon Energy (LSE: SLE) has recently started shale production in Poland, but the overall Polish story does show that high initial expectations can be followed by disappointment.
7. Environmental issues
I’m not going to debate fracking’s environmental impact in this article. All I’ll say is that environmental issues may affect government policy in the future. Granted, our current government is sympathetic to fracking, but we can’t be sure that future governments will see things the same way.
The French government doesn’t permit fracking at all, and there’s a chance that a future UK government could follow that example. And that’s a possibility regardless of whether fracking does or does not inflict serious damage on the environment.
8. Local opinion
The idea of an oil well near our home doesn’t appeal to most of us. I’m sure we’ll see plenty more protests every time a new fracking well is proposed.
Remember also that UK landowners don’t own the mineral rights on their property. So they don’t have any significant financial incentive to support drilling on their land. It’s a different story in the US, where property owners own the mineral rights too.
Getting local people onside is a significant challenge for the fracking industry. Not an insuperable challenge, but a challenge nonetheless. (Although my colleague Matthew Lynn recently looked at a relatively easy way to change this).
9. Fracking won’t lead to dramatic falls in UK energy prices
Fracking has delivered a real fillip to the US economy by driving down natural gas prices there. That’s helped US businesses, which now have lower energy costs than overseas rivals.
But even if shale gas production does take off in the UK, don’t assume we’ll see a similar price fall here. That’s because it’s hard for the US to export natural gas cheaply as there’s not much infrastructure. The UK, by contrast, has the infrastructure. So UK production might lead to a modest fall in the global gas price, but we probably won’t get much of a cost advantage over other countries.
Don’t get me wrong
Don’t get me wrong, I’m not saying that fracking will inevitably fail in the UK. Far from it, I’m very tempted to invest myself and we’ve got plenty of ideas on how to do so in MoneyWeek magazine. I’m just flagging up nine issues to keep an eye on.
For more on the fracking debate, you should take a look at this report from my colleagues over at the Fleet Street Letter.
Former City fund manager comes forward with:
“My top UK fracking investments for 2014”
This year, shale gas – and the controversial drilling method known as ‘fracking’ – could go mainstream in Britain.
Huge amounts of wealth stand to be made if you make the right investment.