Opinionista Ivo Vegter 5 November 2013

Forever blowing bubbles: shale gas economics

All a pessimist has to do to sound intelligent nowadays is to call a successful industry a “bubble”. So it is with Arthur Berman, an old-school Peak Oil alarmist who has been banging the oil drum against shale gas for years, and made the Sunday Times this weekend.

The efforts by environmental activists (and some activist journalists) to convince policy makers that shale gas is a grave risk to human health or the environment have failed.

South Africa has issued exploration permit regulations for public comment (you have until next week). They include strict demands to adhere to set standards at every stage of well drilling, production and abandonment. It covers water use, fracking fluid handling and waste disposal in detail. It addresses even the most controversial points, such as chemical disclosure.

Pending public comments, permits for exploration will be issued next year, and gas drillers, scientists, regulators and environmentalists will spend anywhere between three and nine years figuring out how much gas there is, whether it can be profitably extracted, and how the risks of extraction can best be mitigated. If all goes well, production will start thereafter.

The UK’s health authorities have also recently played down concerns.

Still, there are people who remain skeptical that South Africa can use an abundant supply of natural gas of its own. They seem not to think Eskom needs to explore every avenue towards solving our electricity crisis. They probably haven’t thought that industry could benefit from lower input costs, the unemployed could use a few jobs, consumers could use cheaper, safer, cleaner electricity, and that exporter revenue could use a boost.

So now they’re trying their hand at economic arguments to suggest that the benefits of shale gas are oversold. They point out the inability of economists to accurately predict the future. They say government cronyism and corruption will undermine the potential benefits. Presumably, they hope to convince us that there will likely be no benefits at all, and therefore, shale gas permits should not be issued.

My editor found a great example. He called me up, and said, “You know I’m not a big fan of fracking, but you’ve got to read Ray Hartley in the Sunday Times.”

I did. I can see why a reader who knows something about shale gas might be startled. Hartley claims that “the fracking fantasy falters”, as “shale gas is slated as a commercial failure in the US”. On his blog, he rephrased the headline, warning against a shale gas “boondoggle”.

Let’s not quibble for the sake of it. The shale gas boom has all the hallmarks of a bubble. It would be astonishing if it didn’t, because it has been so spectacularly successful, and success attracts lots of capital, lots of speculation, and lots of risk-taking. Some investors are bound to get burnt.

But that does not mean, as Arthur Berman, the main source in Hartley’s Sunday Times piece, put it, that shale gas is a “commercial failure”.

In the US, the consumer price of natural gas – what industry and residential users pay – has been steadily declining since the shale gas boom started in 2008. US electricity prices are lower now than before the crash of 2008, while those in Europe have been rising sharply. The US has the most affordable electricity in the world, according to South African economist, Mike Schüssler.

Berman calls it a “commercial failure”.

Thanks to shale oil and gas, the US has become a net petroleum products exporter for the first time since 1949.

Al Jazeera says, about US shale plays: “Some industry veterans believe it’s the biggest development in the energy game since 1859, when the first US oil well gushed from beneath the earth in Titusville, Pennsylvania. In changes that would have been unthinkable just five years ago, the US is set to become a net energy exporter in the next few years.”

And Berman calls it a “commercial failure”.

A Federal Reserve economist reportedly put consumer savings at $16.5 billion a year as a result, and Nobel laureate Robert Solow, said that would add significantly to US GDP. A study by IHS, a US research firm, found that, on average, every US household is saving almost $1,000 per year.

IHS also reports that shale gas production supported more than 600,000 jobs in 2010, a number that is projected to grow to nearly 870,000 by 2015. It contributed $77 billion to GDP in 2010, and will contribute $118 billion in 2015. It will generate almost $1 trillion in tax revenues over the next 25 years.

Berman calls all of this a “commercial failure”, and that claim meets with no skepticism from the Sunday Times.

Will all this bounty last forever? Of course not. Individual wells have limited, and varying, productive lives. Some produce gas for 20 years or more, while others are depleted after five years. Especially when prices are low, production growth curves will naturally slow down. The price mechanism is supposed to do that: balance supply with demand. If demand rises again, more marginal production will also grow. It’s not like the world is going to run out of promising shale gas plays any time soon.

More importantly, some other energy source will eventually become economically more attractive than shale oil and gas. The decarbonisation of fuel – from wood, to coal, to oil, to gas, to nuclear, solar, wind, and even hydrogen – continues apace. In simplistic terms, decarbonisation refers to the gradual transition to fuel sources with more hydrogen atoms and fewer carbon atoms. This makes each new fuel more efficient, provided its extraction is technically feasible and cheap enough.

So, what does it mean to describe shale gas as a bubble, if it doesn’t mean “commercial failure”?

Speculative bubbles have a rich and storied history, dating back to the tulip mania of 1634 to 1637 and the South Sea bubble of 1711.

The development and popularisation of the Internet was the cause of the most famous industry-specific “bubble” in recent memory: the dotcom bubble. For many journalists, it was a defining event in their careers. It blew all records in the late 1990s, before the crash began in March 2000.

I didn’t believe the eye-watering price-earnings ratios at the time, but called the top six months too early, in September 1999. Many other journalists did buy the hype. Humbled by the crash, they were primed to try to spot new bubbles early, in the hope of looking smart when it bursts. Even so, most missed the housing bubble of 2007 too, even though libertarians like congressman Ron Paul declared it to be inevitable as early as 2001.

Let’s define what we’re talking about here. A bubble forms when an industry attracts investment, driving up asset prices such as stocks. Usually, this boom is well justified by the market’s fundamentals, but the notion that individuals are rational economic actors is, of course, false. Markets might be rational in the long run, but individually, and over short periods, people can be subjective, excitable, fearful, confused, misled, and irrational.

Hype about a new and profitable technology or industry can drive a market’s value higher than underlying fundamentals justify, which leads to a correction, as confidence withers. That sell-off usually overshoots the true value mark, too, before the market matures, asset prices stabilise, and the benefits of the industry become widely distributed.

What this really describes is a perfectly ordinary cycle of investment being directed by rising stock prices to where it is needed, and later directed by falling stock prices to move elsewhere. The distinction between a bubble and normal market operation is one of degree, not kind.

Despite the bubble and the subsequent crash, we all use an Internet that is vastly more sophisticated than anything produced during the dotcom boom. Tech companies are still attracting vast amounts of capital, they’re still innovating, and consumers are still benefiting from more features and power at lower prices every year.

The dotcom bubble was ruinous for some investors, certainly. But the Internet was not a “commercial failure”. It made others spectacularly rich. The hyper-competitive market did destroy many companies, and greedy recklessness or outright fraud destroyed many more. However, the smartest and strongest survived.

Despite the “commercial failures” of many Internet ventures, we have smart-phones today that respond to hand gestures and eye movements, and can tell us we’d better leave for the airport in 15 minutes or we’ll miss our flight.

So merely identifying a bubble is of interest to investors, but it doesn’t say much about the ultimate value, to consumers, of an industry.

This is even more true in the shale gas industry. Unlike in the IT sector, should the gas bubble burst, switching from a failed supplier to a survivor is trivial, so even big customers won’t have a great deal to worry about from a market shakeout.

Is such a shakeout likely? Certainly. Any industry that shows great potential attracts speculative money, from investment banks that need to beat the market, to middle-class wage slaves dreaming of striking it rich. When credit is cheap and cash returns are low, which the easy money policies of central banks have ensured for years now, speculative bubbles are inevitable. And they’ll happen in the industries with the best prospects.

Many of the small players in the shale gas boom could become ten-baggers, but the bigger the upside, the bigger the risk. Larger companies promise more safety, but even some of them will likely fail, or write down their shale gas holdings.

Infamously, Forbes magazine called Chesapeake’s founder and CEO, Aubrey McClendon, “America’s most reckless billionaire”. Six months later, Rolling Stone’s Jeff Goodell got the memo, and wrote a hit piece on the company’s speculative land lease plays and its precarious financial position, calling McClendon a scammer. The company spun it coolly, but Goodell hit back.

I’ve written about Rolling Stone’s fracking exaggerations before, noting that they managed to fit “fracking” “bubble”, “toxic”, “right-wing”, “billionaire”, “profits”, “flipping”, “boom”, “scam” and “hot air” all into one headline and one introduction. So I’m inclined to believe Chesapeake’s scepticism of Goodell’s aims. However, he will consider himself vindicated by Chesapeake’s decision to nudge McClendon into retirement in April 2013.

McClendon did seem reckless, but in a way, he was the victim of his own company’s success. Chesapeake spearheaded the shale boom in the US. This caused a dramatic rise in gas and oil supplies, with a commensurate spike in the company’s stock price. That provided the business with much speculative capital, which it, naturally, invested in securing land leases to lock in future prospects and lock out would-be competitors.

The supply boom, however, caused prices to collapse. US wholesale gas prices fell to as low as $2 a unit, while Europe was still charging $9, and Japan prices had risen to around $16. Chesapeake’s debt burden proved unaffordable in the face of low prices and sometimes disappointing productivity from the speculative land leases on which the company gambled.

The US gas price has recovered a little, but many US companies are still eyeing exports to more profitable climes. Some do so by contracting South Africa’s own Sasol for billions of dollars to build facilities to convert gas to liquid fuel, and create thousands of jobs. In America. For Americans.

Many predicted Chesapeake’s demise last year, but the new CEO, Robert Lawler, seems to be turning the ship around. Recently, stock tipsters have been bullish about its prospects again.

McClendon, meanwhile, is pan-handling outside investment banks again, to fund a new venture called American Energy Partners. The Wall Street Journal is not certain he’ll get what he wants.

If the dotcom bubble didn’t teach us enough, Chesapeake is another object lesson in how hard it is to predict markets. And Berman is not particularly well placed to prognosticate. He is a member of the Association for the Study of Peak Oil, whose track record of alarmism is dismal. He’s been preaching against shale gas for years, too, so investors are well aware of his claims. Second-guessing those investors on the basis of just one Cassandra’s skepticism is a mistake no journalist should make.

In any case, even if he’s right, whether shale gas is profitable for a given producer in a particular place is really the producer’s problem. The question for public policy is whether shale gas production ought to be permitted, and whether consumers and the economy at large might benefit.

Let’s consider a few more issues raised by the Sunday Times before we dismiss its economic pessimism and the activism that it promotes, and instead highlight the real risks.

Hartley raises questions about the economic projections commissioned by Shell from the late Tony Twine, of Econometrix.

Twine was reportedly very excited about the potential of shale gas. He had a heart attack three days after the report was released, and died a week later. According to his business partner, Azar Jammine, as quoted by Alec Hogg, Twine couldn’t handle the hate and abuse directed at him by the anti-shale gas lobby. I have faced it myself. I do not think this a far-fetched claim.

Hartley mentions a critique of Twine’s paper commissioned by the environmental lobby, which says Twine declared uncertainty in many of the report’s assumptions, as if that invalidates its conclusions. It does no such thing. On the contrary, it marks Twine as a cautious economist who knows the limits of his profession. Those uncertainties made him careful to use very conservative estimates, and justify them throughout the report.

Hartley writes: “Contrarian commentators, government officials and energy bulls quickly turned Twine’s most improbable outlying scenario into the mainstream consensus.”

That’s odd. I suppose I am a “contrarian commentator” on shale gas, having written dozens of articles and part of a book on shale gas since April 2011. I have always said I base my view in favour of shale gas on the expectation that only a fraction of Twine’s low-ball scenario will come true.

For example, I wrote: “One may have grave doubts about this [method] of economic forecasting (and I do), but if even a small fraction of the anticipated benefits are realised, the benefits would outweigh the risks.”

And I wrote: “It is always reasonable to be sceptical of economic forecasts, but if even a tenth of the anticipated benefits materialise, it would be worth going ahead.”

I’ve been to several conferences on shale gas, and while industry speakers do mention Twine’s higher estimates, I’ve never had the impression that they predict this with any confidence, omit the low-road scenarios, or ignore the uncertainties.

Hartley’s piece is shot through with such glib presumptions. I’ve never heard shale gas described as a “magic bullet”. Everyone with an ounce of sense views it as a promising resource, that may have great economic benefits. Every petroleum geologist, drilling engineer, or industry marketer I’ve heard on the subject says, cautiously, that they cannot know for sure how promising the resource is until the government permits exploration.

Nobody claims it will create hundreds of thousands of direct jobs. Everyone who knows what he’s talking about says there may be some direct job creation, at all skill levels, but the greater benefits, for employment and economic growth, will come from indirect support industries, and from the broader impact of an abundant source of industrial heating energy and an efficient alternative for generating electricity.

Activists opposed to shale gas are quick to latch onto uncertainties, or changing forecasts, to suggest that risks are grave, and benefits are negligible.

Recently, a new British estimate slashed expected job creation due to shale gas in that country to a third of what was initially anticipated. Here’s how Greenpeace interprets that: “There goes the ‘new jobs’ argument for fracking.”

As if 24,000 jobs gained is nothing. It then repeats the false dichotomy that “green tech will provide more jobs”, which ignores that such predictions are equally uncertain and are in any case dependent on lavish government subsidies and carbon taxes.

One expects that kind of rhetoric from a radical activist group. One does not expect it from a journalist. Describing shale gas as a “commercial failure” in the US is blatant propaganda. It is not just wrong. It appears to be deliberately designed to mislead.

So, what are the risks? Hartley is right to warn that a shale gas boom may have a negative effect on the coal mining sector. Lamenting that seems odd, since that is exactly  what most policy – economic and environmental – aims to do. Crying crocodile tears over the decline of an old industry as it gets displaced by a newer, more efficient industry, seems to deny the very notion of economic progress.

A far more pertinent risk is that of large state-owned stakes in shale gas producers, which will make South African shale gas less attractive to petroleum industry investors. There’s also the risk of cronyism and corruption that so often attends new business ventures in which the government has a say. One might hope that the revenues that accrue to the state will be used to better fund the regions in which shale gas drilling takes place. They can certainly use some development. Skepticism that this will happen is well-founded.

Finally, there is the risk to land-owners. They only face risks, however minor, with no real claim on any revenues produced, since mineral rights were expropriated from them a decade ago. They deserve some upside. A lobby group that fights for the rights of landowners to profit from the bounty under the surface would get my support.

These are the risks that a vigilant media and activist civil society ought to focus on.

The failed campaign to exaggerate environmental risks has harmed the standing of both activists and the media with government. It will forge ahead, because it rightly believes the economic benefits far outweigh the risks.

A protracted legal campaign claiming there was insufficient contemplation and consultation over the last three years, even while exploration permit regulations are open to public comment, will only make activists seem dogmatically obstructionist. They admit openly that it will cost taxpayers millions, which is hardly likely to boost their standing with the government, industry, or the public.

Switching to patently ridiculous claims about the “commercial failure” of shale gas in the US, to suggest that none of the potential benefits will materialise, just makes the activists (and the journalists that parrot them) look clueless.

More’s the pity. Constructive engagement with government and industry to ensure that risks are mitigated, and benefits for all South Africans are maximised, might have done this country a great service. One would swear this was never what they were after. DM

PS. Despite its length, I missed one other very valid risk Hartley raised. Shale gas, provided it is cheaply available and doesn’t have to be transported far, is an ideal source of electricity. Gas turbines are inexpensive, compared to coal or nuclear power stations, and can produce both base- and peak-load power, unlike renewables. They also burn far cleaner than coal, emitting almost no pollutants and only half the carbon dioxide. The question is whether Eskom will use shale gas and pass the benefits on to consumers. Rationing of industrial users ought to end, and prices ought to decrease (or increase less than they otherwise would have). In our statist world of controlled tariffs, rather than competitive prices, the fear that they won’t be passed on is valid. Pressure will need to be placed on them and the government to ensure electricity users do benefit. Of course, not producing the gas in the first place would be the best way of all to ensure consumers do not benefit.


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