Fracking: Nine reasons not to get carried away

Governments may not always be as sympathetic to fracking as the current one

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.

Read more about the Polish story here and here.

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.

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9 Responses

  1. 14/02/2014, Sceptic wrote

    With regard to point 007, the French don’t permit fracking at all, well its the French company Total over here (Barton Moss) licenced to drill!
    The French aren’t daft.

    Also, we hope that the fracking companies are held to account for clearing up the mess afterwards (USA in mind).

  2. 14/02/2014, Ed Bowsher wrote

    Hi,

    No I hadn’t read Terry Smith’s article when I wrote this piece, but I’ve seen it since. That’s because one of my colleagues spotted it and put it in our ‘Fracking news from around the web’ which you can find on our ‘Fracking revolution’ hub page. http://moneyweek.com/the-fracking-revolution/

    I think it’s fair to say that we’re still bullish on fracking here. I just thought it would be useful to put both sides of the argument.

    Ed

    • 15/02/2014, haircut wrote

      From the hyperbole of ‘fracking bonanza’(15 nov 13) to ‘nine potential problems that might reduce returns for investors or possibly mean investors don’t make any money at all’

      Good grief! Perhaps we haven’t missed the bandwagon of obfuscation.

      Be handy article though if shale does turn out to be a dud call !

      • 15/02/2014, haircut wrote

        Handy article as in a ‘get out’, is what I mean.

  3. 16/02/2014, mikeT wrote

    So the US has cheap gas because it cannot export into high-price markets and the UK’s potential natural gas will simply be sold to the highest bidder abroad (because we have the pipelines). However, despite the Polish experience, there are still plenty of reserves in mainland Europe (no?), some of which will be economically viable. This raises the prospect of Russia becoming the new “OPEC”, reducing its supply to “maintain price stability”.
    So, it might be true that we will not see lower domestic prices in the short-term BUT other benefits will accrue. The UK will have a new, productive manufacturing sector – a real asset – that should help correct all sorts of imbalances (trade, current account, sterling etc) and even contribute to national debt reduction with increased tax revenue, employment and so on. There are still reasons to be optimistic. I think.

  4. 17/02/2014, Professor Rhubarb wrote

    All the hype about fracking is so reminiscent of the hype around nuclear power in the 1950′s when we were told that energy would be so cheap it wouldn’t be worth metering. I’m staying well clear

  5. 18/02/2014, Rookie wrote

    Nice article Ed and thanks for outlining the pros as well as the cons this is surely what any savvy investor or columnist would do! I certainly wouldn’t call this back tracking. I know of no one on gods green earth that can accurately predict economic outcomes.

  6. 19/03/2014, Howie Gibbons wrote

    I spent my entire working life in the petroleum exploration and production industry. Hydraulic fracturing for enhanced oil recovery was around for all of the time I spent in the industry, and was used to bolster rates of production or to extend the planned lives of reservoirs and to increase the percentage of hydrocarbons that could be produced.

    It is an expensive procedure that often requires repeat treatments that usually result in ever diminishing outcomes.

    To call the application of a procedure that has a proven if often unconvincing economic good in conventional hydrocarbon capture, to the more demanding requirements of shale gas/oil recovery a magic bullet for all our energy needs is way beyond hyperbole.

    This technology, which the horizontal drilling into shall reservoirs is more complex than conventional vertical wells often with more problems and greater cost. The fracturing and propping of the fractures, this is needed to prevent the fractures from simply closing when applied pump pressure is released, requires complex and expensive carrier fluids to deliver the treatments to the formation to be exploited.

    As can be seen in Wyoming and other places in the US quite often the wells have short lives and many operators declare themselves bankrupt to avoid the cost of abandonment and environmental reinstatement.

    This is not a viable solution to the energy needs of the UK as the associated costs are too high for the energy recovered. It might become more economically viable in the future if wholesale costs of imports soars but I have grave doubts that this will be the case.

    It makes much more sense to me to invest tidal energy projects despite the high capital costs that these carry.

  7. 01/05/2014, Pinkers Post wrote

    Thank you for this brilliant analysis! For once, a voice of reason in this increasingly hyped debate! No harm looking at recent developments in the US

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