Assessing the longer-term prospects of an energy revolution

The shale energy revolution has already upset the peak oil forecast, which predicted that the world will soon reach the point of highest physical oil output and thereafter global production will begin an inexorable decline. Now, in the context of the worsening political situation in the Middle East and Eastern Europe, its impact is being discussed in terms of America’s ability to secure its own energy supplies and assist its allies with theirs. The near-term enthusiasm for shale energy is understandable, but what are its longer term prospects?

Energy markets are notoriously difficult to predict. In the 1970s, as U.S. oil production reached a historic high point and turmoil in the Middle East produced two spikes in crude prices, there was talk of imminent scarcity. While global output stood at around 60 million barrels per day (mbd), some analysts declared that the world would be just about out of oil by this time.

However, far from going straight up, oil prices actually fell throughout the 1980s and 1990s, and, without any major new sources of supply emerging, reached $10 per barrel. Since the start of the new century, however, prices have been driven by the rise of China and rapid economic growth in emerging economies. The number of cars plying roads around the world increased from 750 million in 2000 to 1.2 billion currently. This has been the main reason why oil production kept rising, and now stands at around 90 mbd, whereas oil prices jumped roughly tenfold.

By 2050 there may be up to 3 billion cars in the world, possibly requiring oil production to increase to 120150 mbd.

Apparently we face an age of scarcity in which energy prices will go ever higher. Or do we? The shale revolution changed the dynamics of the energy market. U.S. oil production is now the highest it has been in 27 years, and there is enough domestic oil to meet 84% of US demand. By 2016, domestic output should set a new all-time high and some forecasts expect shale oil production to reach 5 mbd by 2017.

Other countries, including Mexico, China and Brazil, are exploring their shale deposits as well. There has been something of an oil glut developing around the world and oil prices, despite political concerns focused on such oil producers as Libya, Iraq, Iran and Russia, have been generally soft.

Adding to the softness of the oil market has been a complementary natural gas boom, also from shale. Over the past decade, gross natural gas withdrawals in the U.S. rose by a third, prices declined and demand for gas for home heating spiked, while heating oil demand plummeted. Shale gas accounts for about half of U.S. domestic natural gas production, up from a very small percentage a decade ago.

During the past decade, oil prices have been uncharacteristically volatile, suffering an 80% drop, peak to trough, during the 2008 financial crisis, then staging a three-year rally which saw crude prices quadruple. This indicates, above all, considerable uncertainty as to where prices will go. However, over the past two years volatility has moderated substantially, suggesting a kind of truce between supply and demand.

In other words, demand has been growing as predicted and supply has been increasing apace to achieve price equilibrium. Any change in expectations could lead to a precipitous drop to $60 per barrel (a bearish forecast) or a jump to $150 per barrel (a bullish view).

Oil bulls tend to be pessimistic about the prospects of shale energy. Their case is twofold. One is financial: Shale energy is costly to produce, so the current boom could only happen amid high oil prices and thus contains the seeds of its own destruction. There have been moments when natural gas prices fell so low that some wells stopped production. The same could happen to shale oil producers if the oil surfeit they engender brings down prices.

Besides, shale producers have used debt to fund their exploration and production, which has been both easy and cheap in a low interest rate environment. If economic growth accelerates, interest rates will rise, as well, hurting shale oil producers.

The other problem is technological. Fracking, the technique needed to break up shale rock to get to the oil and gas layers located in-between, is not especially friendly to the environment. It requires vast amounts of water, chemicals and sand to be pumped into wells. Residents have been up in arms in some densely settled areas, and their opposition will raise the cost of producing shale energy still higher while reducing the amount of recoverable oil and gas. In some countries, notably China and India, the shale boom may not even happen, at least in the near future, because of the scarcity of water in the areas where shale oil and gas deposits are located.

Finallyand most importantlywhile yielding a lot at the start, shale oil and gas wells tend to be exhausted faster than conventional ones, which in some cases produce for decades. Shale gas wells, for example, typically halve their output after the first year of operation. Now that the most accessible and productive deposits have been worked, companies are forced to drill thousands of new wells every year just to keep up production. Producers may have to spend $35 billion annually on new drillingmuch of it in borrowed funds. The government warns that all technically recoverable shale gas will be pumped out by 2030.

While oil bulls cast doubt on shale energy production, oil bears scrutinize the demand side. There is no question that demand for energy has exploded thanks to faster growth in emerging economies and the expansion of the global middle class. However, just as shale energy producers have relied on cheap, plentiful money, so the ongoing global economic boom owes much to worldwide monetary ease. An eventual tightening could send a number of countries into an economic downturn.

A self-correcting mechanism also exists in oil prices. True, many Chinese, Indians and Brazilians have been eager to get behind the wheel of a private car. But would they drive quite as much if oil prices rose to $150 per barrel? A number of poor countries provide fuel subsidies for their consumers, shielding them from the impact of still-high gasoline prices. However, fiscal retrenchment has now become global, and governments are being forced to cut or eliminate such subsidies to save money.

Transitional Period

The fracking boom is unlikely to be the panacea some of its supporters have been touting. There are considerable deposits of shale oil and gas around the world but there are plenty of reasons why it will be costly or technically difficult to tap them, and why some deposits may prove non-recoverable. More to the point, even a highly successful shale oil revolution will not disprove the peak oil theory: Eventually the world will run out of oil, no matter how many more unconventional reserves we discover.

But pessimists are also wrong. Shale energy has already had a substantial impact on energy markets, proving it is no flash in the pan. One reason it will continue to play a major role is that technology does not stand in place. Shale oil and gas will keep getting cheaper as technology develops and economies of scale are achieved, allowing producers to recover more oil and gas, and to do so more cleanly.

Technology is key. Since the advent of the IT revolution we have discovered that old style jobs in manufacturing and services simply don’t pay well and are being automated out of existence. What pays instead is innovation. The same is true of the production of natural resources. Even though commodity prices have been historically high, simply pumping commodities out of the ground is ultimately a race to the bottom. That’s because the innovative economy of today will inevitably discover cheaper ways to produce those commodities, or find substitutes for them and ways to use them less.

All of this will be happening in and around the shale energy industry. Liquefied natural gas has opened up overseas markets for U.S. shale gas. In a few years LNG will provide for energy security in Western Europe vis—vis Russia, currently its main natural gas provider.

Aside from cutting costs, improving recovery rates and making production safer for the environment, innovation will move in the direction of energy saving technologies and toward other forms of energy, including renewable energy. Ironically, investment in innovation will be spurred if oil prices stay near their current levels or temporarily move higher.