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The ‘shale revolution’ ends with a bang

Image: Bryan Burke

As British frackers struggle to drill a handful of test wells, the US ‘shale revolution’ on which their efforts are predicated looks to be coming to an end.

The reasons for its demise will send shivers through UK investors as they realise that it has nothing to do with the quantities of oil and gas beneath the ground.  Even if British frackers find gas beneath Derbyshire, Lankashire, Sussex or Yorkshire, their industry will be dead before any meaningful amount can be brought to the surface.

The first alarm bell sounded in the US, when bullish oil trader Andy Hall – who goes by the nickname “God” among energy investors – announced the closure of his flagship hedge fund at Astenback Capital Management LLC; apparently having reached the point where he is no longer prepared to throw good money after bad on an industry whose demise is guaranteed with oil prices below $100 per barrel.  Behind Hall’s decision is the calculation that fracking firms have been cutting the amount they spend on future exploration and production in order to maintain a positive cashflow:

“The likeliest culprit is fear that, even if oil prices aren’t falling further, they are low enough to affect E&P firms’ growth plans — as evidenced in guidance given on a number of quarterly earnings calls this week and last.

“Still, even with a few percentage points taken off some growth plans, they remain pretty punchy. I think the real problem here may be more existential than some tapping of the brakes.”

This view is consistent with that of energy analyst Ellen R. Wald in an article for Forbes this week Wald takes issue with the popular view (i.e. the view in the fracking company investment brochures) that the reason for the fall in oil prices since 2014 is because of improvements in fracking technology and the opening up of new shale discoveries:

“Recently, however, industry experts and economists have begun to offer other, more plausible, explanations. Some experts, such as Art Berman, have explained that the lower costs were largely due to lower labor costs in a depressed market as well as desperate vendors giving discounts.

This is in line with our own argument that fracking is only cheap so long as nobody actually does it.  As Wald notes:

“It appears that most of the drop in the breakeven point for shale was not due to technology or newly-discovered efficiencies in the last couple of years. Compared to most offshore or conventional drilling, shale oil production is still a service-heavy industry. And those service costs (and payroll costs) seem to be falling and rising in line with the movement of oil prices. This would mean that when oil prices rise again, so would the costs to shale producers.”

Far from being a ‘revolution’ or a ‘technological breakthrough,’ fracking always was and always will be a story about greed.  Seven years ago, when oil prices soared above $100 per barrel, and when the US Federal Reserve had set interest rates at a quarter of one percent, shale oil and gas production appeared to be one of the few places where investors could get an above inflation return on their investment.  The trouble was that the investment contracts focused on production growth, with a view to maximising the return on investment as quickly as possible.

In this respect, fracking became a victim of its own success.  After all, the shale plays were well known and the drilling technologies well understood.  Price was the only reason they had not been developed before.  Unfortunately, the dash for fracking fed into a global surplus of oil and gas at a time when recessionary forces were driving down demand in the USA, UK and Europe.  The result was the sharp fall in prices and their refusal to bounce back since 2014.  Persistent low prices have effectively holed the US shale revolution below the water line.  As Wald points out:

“The Shale Revolution has a big problem. It is heavily dependent on institutional investors and lenders, and they are starting to lose interest in the business. Investment in shale has benefited from a Silicon Valley-like syndrome of focusing more on growth than profitability.

“The crux of the issue is that the breakeven costs of shale oil production are still too high for the market.”

With high profile investors pilling out and the industry itself struggling with losses, and particularly with rising interest rates paving the way for safer forms of investment elsewhere, we now know how the shale revolution will end – with investors refusing to throw any more good money after bad and simply walking away.  As Wald puts it:

“Wall Street’s growth-at-all-costs mindset is not sustainable over the long-term, and today’s shale firms cannot survive forever without consistent profits . Shale cannot create consistent profits until the costs are detached from the boom/bust wave of oil prices, and the signs are that investors just might be catching on.

“When the financiers lose interest, the Shale Revolution will be over.”

In the UK, where the frackers have yet to pull a single profitable Btu of shale gas to the surface, the problems are even more profound.  News that Barclays was pulling its investment from Third Energy was followed in short order by Cuadrilla’s announcement that it was slashing its workforce and “restructuring” its finances.  Then in July we discovered that the industry had gone cap in hand to the government seeking state support because they couldn’t secure sufficient private investment.

The problem for Britain’s would-be frackers is that the US fracking industry has all of the advantages: a developed onshore oil and gas industry; favourable geology and social geography; looser planning and environmental regulation; considerable political support; and, crucially, Wall Street’s trillions of dollars.  If, with all of this in its favour, the best the US industry can manage is to fall ever further into debt, then the UK industry – which has government support but not much else – is unlikely to get beyond the handful of test wells that it is currently drilling… and these are too few in number to determine the viability of the industry in future. It is most likely that when the US industry crashes, UK fracking will be over for good.

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