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Fracking is cheap… as long as we don’t actually do it

Falling oil prices since 2014 devastated the US fracking industry, causing widespread bankruptcies and leaving a trail of ghost towns in their wake.  But according to the companies that are still standing, technological improvements have brought the cost of fracking down to the point that they can turn a profit at an oil price of just $50 per barrel.

But was technology really responsible for falling costs?

While a degree of automation has taken place, critics of the industry have pointed out that the real reason for falling costs was the bankruptcies themselves.  Supply companies that had turned large profits during the boom dramatically lowered their prices during the slump.  Specialist technicians and engineers who were laid off as the bust gathered pace were prepared to take much lower wages just to stay in work.  It was these falling costs rather than automation and new technology that explained the falling cost of fracking.

Determining which of these two narratives is correct is essential to anyone thinking about investing in a new round of fracking now that global oil prices are rising again.  If the proponents of technology are correct, then the cost of fracking will remain stable as oil and gas production increases.  If, on the other hand, most of the fall in cost was due to spare capacity caused by the slump, then as production increases, the savings will evaporate – rendering investments unprofitable.

Today, following the OPEC decision to cut supply and the ensuing rise in world oil prices (which also tend to set the price of gas), we can begin to see which narrative is more accurate.  US energy companies have begun to frack once more.  Production is increasing.  So what is happening to the cost of fracking?

According to Tom DiChristopher at CNBC the cost of fracking is rising rapidly:

“Denver-based Lilis Energy… recently hired a contractor to drill two wells at a cost of $13,900 per day per rig. Two months later, CEO Avi Mirman said Lilis couldn’t contract a rig for less than $16,000 a day…

“When Lilis solicited bids to frack wells recently, quotes rolled in at about $2.2 million. When it came time to execute two months later, the cost had surged nearly 50 percent to $3.2 million.”

As DiChristopher notes, these are early days and there is still considerable spare capacity in the supply and labour markets.  Most of the new investment in US fracking has gone into the Permian Basin in West Texas, and for now the fracking companies are able to bring supply companies and workers in from elsewhere in the USA.  However, in the event of a more widespread increase in production on the back of higher oil prices, this option will soon be exhausted.  The only way of staying in business will be to raise prices once more.

The lesson from the 2014 collapse in world oil prices, however, is that Goldilocks is Dead – there is no ‘just right’ oil price at which consumers can afford oil and gas and the fracking industry can stay in business:

“For consumers, experience suggests the acceptable oil price zone is $40 to $60 in today’s dollars: higher than that, and goods and services (particularly transportation) become more expensive than current spending patterns can handle. For producers, the acceptable zone is more like $80 to $120: lower than that, and upstream investments make little sense, so production will inevitably stall and decline—eventually making consumers even less happy.”

That doesn’t mean that fracking will come to a standstill entirely.  There are so-called ‘sweet spots’ within the US shale patch where small companies can make a decent living out of $40-$50 oil.  But for the industry as a whole, it is a catastrophe because the economy simply cannot bear an oil price at which fracking is viable as an alternative to what remains of conventional oil and gas supplies.  Indeed, a recent Reuters report suggests that the modest rise in world oil prices since December is already having a chilling effect on the US economy:

“U.S. refiners are facing the prospects of weakening gasoline demand for the first time in five years, stoking fears that earnings this year may be even worse than the dismal performances seen in 2016.

“The sign of weakening U.S. gasoline demand comes as U.S. refiners are in the midst of reporting their worst year of earnings since the U.S. shale boom started in 2011.”

Because the Reuters report concerns short-term data, it is too early to say whether the trend will continue.  However, if it turns out that the US (and by implication the global) economy is unable to bear higher than $50 per barrel oil, then it really is game over for fracking as an industry.

If so, this has serious implications for energy policy on this side of the Atlantic, since the UK government’s long-term energy strategy depends upon a combination of domestic and US hydraulically fractured shale gas to power the economy.  But if the energy industry cannot make fracking work in the USA – where they have all of the natural, political and economic advantages – then there is simply no way anyone is going to make UK fracking profitable on the scale required.  Yes, we too may have a handful of sweet spots where a small company might turn a profit from supplying a modest amount of gas to a nearby power station.  But the government’s bet that we will be able to cover swathes of the UK countryside with fracking wells is looking more and more like economic insanity.

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