Debt, decline-curves and market failure: how the frack is the shale industry clinging on?

If nothing else, the shale industry manages to produce a steady flow of controversy. Hydraulic fracturing – or ‘fracking’ – involves pumping sand, water and chemicals into a horizontal channel drilled deep into shale rock, in an attempt to drive trapped oil and gas to the surface. Groundwater pollution from chemical ‘flowback’ is an obvious concern, along with earth tremors, gas leakage from wellheads [1] (which contributes to global heating) and extensive damage to local roads caused by traffic attached to well operations [2]. However, the major source of friction in the battle over fracking is that environmental, and by extension social, problems are usually pitted against shale’s mooted economic benefits [3] in a confusing, incongruous showdown. In short, the debate often isn’t being conducted in the same language.

Uncontested by environmentalists, the economic story of fracking doesn’t of course really need to make any sense. This is just as well, because fracking really doesn’t make any economic sense. More than that: without the market failures that fostered its growth and development, the shale industry might never have taken off in the first place. Perhaps the most pressing problem for the shale industry is its unprofitability and mounting debt. The enormous capital intensity of fracking operations, and the cost of constantly replacing wells due to steep output decline rates [4], led US Exploration and Production (E&P) firms to increase their net debt from $50bn to $200bn between 2005 and 2015. Companies’ saving grace was that over the same period the cost of servicing that debt only increased from $4b to $10b per year, owing to record-low interest rates [5].

Allocative efficiency, according to neoclassical economics, relies upon individual firms seeking to maximise their profits [6], but unprecedented access to cheap capital has largely removed that imperative for E&P firms [7]. The problem is compounded by that fact that industry executives tend to be paid – and companies valued – on the basis of production growth and proven reserves, not shareholder returns [8]. The misallocation of scarce resources to uncompetitive shale companies is at once a market failure, and a major factor in the industry’s tenacity.

A second set of problems for the industry pertain to economic efficiency, which can be demonstrated through reframing the environmental problems linked to fracking as ‘externalities’. In theory, efficient markets are supposed to attach prices to all the costs and benefits associated with a productive process. An allocatively efficient market ‘prices in’ ‘externalities’ – or factors external to the market – as costs, including the environmental damage caused by fracking [9]. In reality, the notion that the environmental costs of fracking can be accurately quantified, let alone reflected in the relative cost of production for shale companies, is absurd. Under US federal law, for example, E&P firms aren’t even required to disclose what fracking chemicals they are using, let alone cover the wider costs of their use [10].

Similarly, methane leakage both contributes to water contamination[11], and produces imprecise costs associated with a changing climate; markets cannot feasibly ‘price in’ either. The market fails because environmental ‘externalities’ inevitably persist outside it. Socioeconomic ‘externalities’ linked to fracking are also a cause for concern. For example, the risk of tremors and the reluctance of US insurance firms to cover properties near fracking pads has depressed house prices in some areas [12], while increased traffic around the Eagle Ford shale field in Texas has been linked to a 49% increase in road fatalities and severe injuries between 2009 and 2013 [2]. Another major social risk stems from the fact that much of the money invested in shale has come from pension funds, which directly ties the fragile, heavily indebted industry to the economic security of millions [13, 14].

Challenging the shale industry’s broken economic narrative head on is vital if we are ever to completely put a stop to the environmental destruction wrought by fracking. Divestment from shale sends a strong message to shale companies; it also has the added benefit of tackling public exposure to industry liabilities. Investment capital is already leaking from the industry, with banks expected to reduce the value of new loans to weaker E&P companies by 10-25% in 2020 [15]. Investor pessimism too has already led US producers to reduce the number of working rigs by 14% over the past year, with further declines in output expected [16]. 

Stricter regulations on chemical usage, lower tolerance thresholds for earth tremors and financial resilience testing (as applied in the UK [17]) also have an important part to play in correcting the market failures fuelling shale. Activism, too, is essential for highlighting the environmental damage caused by fracking, and in preventing firms (such as Cuadrilla in the UK) from gaining a long-term foothold in the energy sector. That said, nothing – ultimately – beats an outright ban.

References

1. Meng, Q.2017. The impacts of fracking on the environment: A total environmental study paradigm. Science of the Total Environment. 580, pp. 953-957.
2. Rahm, D., B. Fields, and J.L. Farmer.2015. Transportation impacts of fracking in the Eagle Ford shale development in rural south Texas: Perceptions of local government officials. Journal of Rural and Community Development. 10(2).
3. Kirk, J., D. Nyberg, and C. Wright. 2018. Dash for Gas: Climate Change, Hegemony and the Scalar Politics of Fracking in the UK.
4. Wachtmeister, H. et al.  2017.Production decline curves of tight oil wells in eagle ford shale. Natural Resources Research. 26(3), pp. 365-377.
5. Azar, A. 2017. Reserve base lending and the outlook for shale oil and gas finance. Columbia Center on Global Energy Policy working paper.
6. Daly, H.E.1992. Allocation, distribution, and scale: towards an economics that is efficient, just, and sustainable. Ecological Economics. 6(3), pp. 185-193.
7. McLean, B. 2018. Saudi America: The Truth about Fracking and how It's Changing the World. Columbia Global Reports.
8. Reuters.2017. Investors push U.S. shale firms to separate executive pay from drilling. [Cited 2019 15 November].Available from: https://www.reuters.com/article/us-usa-oil-compensation/investors-push-u-s-shale-firms-to-separate-executive-pay-from-drilling-idUSKCN1C42RZ.
9. Goodwin, N., et al. 2015. Macroeconomics in context. Routledge.
10. U.S.C.2015. Energy Policy Act of 2005. U.S.C., Editor.
11. Osborn, S.G. et al.2011. Methane contamination of drinking water accompanying gas-well drilling and hydraulic fracturing. Proceedings of the National Academy of Sciences. 108(20), pp. 8172-8176.
12. Barth, J.M.2013. The economic impact of shale gas development on state and local economies: Benefits, costs, and uncertainties. New Solutions: A Journal of Environmental and Occupational Health Policy. 23(1), pp. 85-101.
13. FT. 2018 .UK local government pension funds invest £9bn in fracking companies. [Cited 2019 15 November]. Available from: https://www.ft.com/content/fdbfe85a-609f-3ec5-b20e-12dc873e6f74.
14. OilPrice.com. 2019. Canada Pension Fund Boosts U.S. Shale Presence with $3.8 Billion JV. [Cited 2019 15 November]. Available from: https://oilprice.com/Latest-Energy-News/World-News/Canada-Pension-Fund-Boosts-US-Shale-Presence-with-38-Billion-JV.html.
15. FT. 2019. Investors starve US shale drillers of capital.[Cited 2019 15 November]. Available from: https://www.ft.com/content/187f8176-f4f4-11e9-b018-3ef8794b17c6.
16. Reuters.2019. U.S. shale firms cut budgets, staff as oil-price outlook dims. [Cited 2019 15 November]. Available from: https://www.reuters.com/article/us-usa-oil-slump/u-s-shale-firms-cut-budgets-staff-as-oil-price-outlook-dims-idUSKCN1VR15P.
17. UK National Audit Office.2019. Fracking for Shale Gas in England.UK National Audit Office.