A read a day keeps the ignorance at bay
28 July 2017 00:45 (South Africa)
Opinionista Ivo Vegter

The WWF weighs in on fracking economics

  • Ivo Vegter
    Ivo Vegter

    Ivo Vegter is a columnist and the author of Extreme Environment, a book on environmental exaggeration and how it harms emerging economies. He writes on this and many other matters, from the perspective of individual liberty and free markets. He is seldom wrong.

Last week, the WWF released a technical report on the economic feasibility of shale gas production in South Africa. One should distrust environmental activists as much as one would distrust corporate spin, and this is doubly true when they prognosticate on matters other than the environment. However, this report proved to be surprising.

No sooner did I think I could give shale gas a rest for a while, when the Worldwide Fund for Nature (WWF) issued a report on the economics of shale gas in South Africa. Sixty juicy pages for me to go through with a toothcomb. What a delight!

The author, Saliem Fakir, is the head of the Living Planet Unit at WWF South Africa. He said he’d look forward to my “independent” opinion (the quotation marks are his, not mine). I was only too happy to oblige.

I have addressed myself to alarmism in WWF reports before, and to the surprising implications of its Living Planet Report in particular, but I was unaware the WWF is also in the business of giving economic advice. Perhaps this reflects a sense that the campaign to block shale gas drilling on environmental grounds has failed.

However, Fakir has done a thorough job of raising the economic issues, given the limited inside information at his disposal and the inherent difficulty of forecasting. Moreover (to juggle three negatives), the report does not conclude that shale gas drilling ought not to be pursued in South Africa because there is no economic future in it. It takes no position for or against drilling, which shows admirable restraint.

Let me quote his conclusion: “...the commercial financial viability of shale gas will be challenging and the success of gas extraction will depend on good knowledge of the geology, efficient application of the technology, the pricing of gas and ensuring sufficiently high standard of measures are taken to deal with both short-term and long term environmental impacts. The economics depends on how [five drivers] converge. They can well facilitate the economics of shale gas or prove to limit and hinder the success and commercial viability of fracking. In the interim the conclusion we draw is that the full commercial exploitation of shale gas in South Africa seems like a distant, if not unlikely, prospect.”

The five key drivers, he says, are the rate at which technology improves, how well drillers understand the local geology, whether oil and gas prices (and other incentives) are high enough, how drilling is timed and scaled, and what the cost of meeting environmental and other licence conditions will be.

I couldn’t agree more. The shale gas industry had far more exciting prospects in the first quarter of 2014, when the Department of Mineral Resources had been expected to issue shale gas exploration permits. Delay may prove to have cost South Africa the chance of a crack at this high-tech resources industry, but much is still subject to uncertainty.

It was not carelessly that I wrote two weeks ago: “We might not enjoy a shale boom like the US, but by prohibiting it, we can be sure we won’t,” and, “We can only hope that exploration is successful and production takes off.”

The WWF report is a good primer on the complex economics that underlie the shale gas industry, but as you might imagine, I do take issue with some of the economic principles Fakir apparently supports.

Even accepting, for the sake of policy relevance, that we labour under a heavily regulating government, Fakir seems to be keen on “strong national sovereignty over resource management and economic planning”.

We’re talking about the same government that has been planning our electricity supply. Let’s not, to misuse PJ O’Rourke’s words, encourage the bastards.

He also adds an observation about “surpluses” or “super-profits” that oil and gas companies supposedly earn, which he says are “not the result of effort, but rather of market conditions”. Fakir believes that “national governments have a right to a part of these revenue streams,” as if ordinary taxes, levies, and free-carry shareholdings are not generous enough.

This is how the price mechanism works, in any fairly free market. Companies that enjoy a lot of upside potential also face greater downside risk. High profits deter consumers and attract rivals, which are appropriate responses to the market’s signal that supply is too low. Conversely, a declining price signals a glut in the market that needs to be cleared.

It is also worth noting that the report consistently misspells “fracture” and “fracturing”. It adds a superfluous “k”, to match “fracking”, the rude sound of which has been very effectively used by the movement opposed to shale gas drilling. The industry’s own alternative, “fraccing”, is equally ugly, but whether inadvertently or by design, such wordplay strikes me as beneath serious commentary.

Economic principles and rhetoric aside, the WWF report rightly points out that the factors favouring shale plays in the US may not be replicable elsewhere. This concern is often expressed among industry insiders and should temper optimism about South Africa’s shale gas prospects.

Among those advantages are private ownership of mineral rights (which suggests that South Africa’s decision to nationalise them was a mistake), and an existing oil and gas infrastructure with well-developed markets.

Depending on forecasts that suppose the build-out of infrastructure such as pipelines and liquid natural gas terminals is, as the report rightly points out, “speculative”. But that is true for any major industry, in any country, as Sasol is discovering over in the US.

The report concedes that there is an element of sovereign risk and energy independence to the pursuit of a shale industry. The less a country depends on the supply capacity, pricing power and political vicissitudes of foreign powers, the more secure its economy will be.

A striking feature of the WWF report is how many variables it covers that are unknown, or subject to uncertainty. It several times adds that these can lead to over-estimating the potential gas reserve, production levels, or well-head price competitiveness. This is true, of course. Few would dispute that it pays to be conservative in one’s economic estimates.

When proposing an economic model for shale gas, the WWF report proposes taking into account more variables than appeared in the report Shell commissioned from the late Tony Twine of Econometrix in 2012.

The Econometrix report predicted widely varying figures for the potential contribution to employment and GDP, ranging from 160,000 jobs and R1 trillion to 700,000 jobs and R5 trillion, respectively. This wide margin of error reflects the inherent uncertainty in speculating about an untested resource.

The WWF report predicts no figures at all, which, frankly, is wise. Besides, the industry’s internal economic viability models will probably be far more complete.

Fakir touches on some of the environmental concerns, including water sourcing and disposal. I won’t repeat the basic arguments about such claims. He is quite right in pointing out that permit conditions to mitigate environmental risk, remediation bond requirements and potential damages claims impose costs on oil and gas companies that would affect the viability of the resource.

The report often returns to an observation that must appear obvious to those in the industry: that unconventional resources like shale gas are harder to exploit than conventional oil and gas reserves. They are, as Fakir puts it, “high-cost, low-producing wells compared to conventional wells,” a fact which is certainly not news to the industry, or to the government. This is implicit in the widespread recognition that the development of unconventional resources, like shale gas and oil sands, has only been feasible thanks to an oil price that had been rising steadily since the turn of the century.

The oil price is ultimately the most obvious feature of the oil and gas market. It is the biggest reason why oil and gas companies might be concerned about the economics of shale right now.

This price is struggling to hang on to $50 a barrel, after holding up around $100 for several years. Citigroup analyst Edward Morse believes it could go as low as $20, which evokes the hardscrabble 1980s and 1990s.

Hardscrabble, that is, for the oil and gas industry. For consumers, a low oil price is great news. It fuels economic prosperity. Whether or not a particular producer can keep their head above water is not our problem.

The main reason for the cheap oil bonanza is American shale. It “has broken OPEC’s ability to manipulate prices and maximize profits for oil-producing countries,” according to Morse.

A bonanza it may be, but the implications for the viability of oil projects and shale gas plays are serious. Charts of breakeven prices for major shale and global oil projects clearly show this. At $50 a barrel, very little is profitable. Below $20, nothing will be.

This would scare the daylights out of me, if I were an investor in oil and gas. A price war is a terrifying thing, especially when the fight is among giant companies and global cartels. When elephants fight, the grass gets trampled.

But I am not an investor in oil and gas. It isn’t my call whether to take the commercial risk.

The government will own a free-carry share of any shale drilling operation, and will receive royalties and corporate taxes. This is more than is demanded of most companies. Net income to the fiscus will be positive in any plausible scenario, unless government goes on an infrastructure splurge with unearned revenue, which one can hardly lay at the door of industry.

Even if you believe government should protect citizens from harm, it is not government’s role to pre-judge the viability of private businesses. It can never outperform the market. It won’t have any more answers than the WWF report provides, and frankly, it isn’t even capable of watching over the viability of its own state-owned enterprises.

Fakir nods cursorily to this point when he writes: “While it is true that private developers should be left to decide the economic proposition of shale gas, extractives are not only about private investment and the associated risks to investors. They also hold relevance for the public sector and society at large.”

This is contradictory. Either the private sector should be left to decide economic viability, or it should not. You can’t have both.

The WWF’s shale gas economics report covers a lot of ground, and offers an excellent overview of the complicated subject of shale gas economics. I must applaud Fakir on a hard job, well done.

However, the most important variables he does not, and cannot, know. Even the exploration permit applicants themselves don’t know. They won’t know until they know the terms of business in South Africa, and are allowed to sink wells to gauge the nature and extent of the gas reserve, four kilometres underground.

Fakir writes: “Only after several drilling and completion results from a well-planned and executed appraisal programme can the true potential of the shale-gas play be determined.”

I agree entirely. If South Africa’s shale turns out to be non-viable, it will not matter whether the government has decided to permit production, because there will be no drilling. If it is viable, the economic fears of those of us outside of the industry will not be relevant. Either way, exploration is the only rational way forward.

If we want answers to the unknowns that the WWF’s shale gas economics report explores, it is time to let the industry’s geologists, geophysicists and engineers get on with it. DM

  • Ivo Vegter
    Ivo Vegter

    Ivo Vegter is a columnist and the author of Extreme Environment, a book on environmental exaggeration and how it harms emerging economies. He writes on this and many other matters, from the perspective of individual liberty and free markets. He is seldom wrong.

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