SNAKE OIL: Chapter 5 - The Economics of Fracking: Who Benefits?

This article is an excerpt from Richard Heinberg’s new book SNAKE OIL: How Fracking’s False Promise of Plenty Imperils Our Future. Given the urgency and importance of the issues we are serializing the book here at Resilience.org.

In the 1980s, two Oklahoma twentysomethings, named Aubrey McClendon and Tom L. Ward, pooled $50,000 of investment capital and started a natural gas company. They decided to call it Chesapeake Energy, since McClendon (who emerged as the company’s moving force) was particularly fond of the Chesapeake Bay region of Maryland and Virginia. From the start, McClendon focused the business on unconventional gas plays and cutting-edge drilling technologies.

Fast-forward to the mid-2000s. As the fracking frenzy was starting to sizzle in Texas and Oklahoma, Chesapeake was there turning up the heat. With the Barnett, Fayetteville, and Haynesville plays yielding shale gas in ever-greater amounts, Chesapeake Energy quickly became America’s second-biggest natural gas producer, and a Fortune 500 company with over 13,000 employees. By 2008, Aubrey McClendon was the highest-paid of all CEOs of S&P 500 companies.¹ In 2011, Forbes named him “America’s Most Reckless Billionaire” in a cover story detailing his lavish and highly leveraged lifestyle.² He owned homes in several states, a mansion on “Billionaire’s Row” in Bermuda, and 16 antique boats worth nine million dollars. He also had a habit of using his property as collateral in order to borrow money with which to buy still more.

Critics began drawing comparisons between Chesapeake and Enron, the energy giant whose infamous bankruptcy in 2001 made it synonymous with galactic-scale accounting fraud. On the surface, they were very different entities: while Enron was a labyrinthine organization with a black-box trading operation and a flotilla of off-balance-sheet shell subcompanies, Chesapeake had real assets in proven and unproven gas reserves and a real product to sell. Still, Chesapeake’s business practices were opaque even to some of its biggest investors, and its cash flow from operations was insufficient to cover exploration and development costs and acquisitions in any of the last 10 calendar years.³

How was Chesapeake making money? Early in the shale boom, the company bought drilling leases at a pace unrivaled; later, it sold bundles of these leases to other operators, many of them European or Chinese, and usually at a profit. Chesapeake was also adept at entering into partnerships and joint ventures. And it used Byzantine financing methods pioneered by Enron in the 1990s—including derivatives, synthetic credit default swaps, and deals financed with little or no equity.⁴

Eventually, crony dealings led to Aubrey McClendon’s resignation as CEO of Chesapeake. News emerged that he had been logging family vacation trips to Europe on one of the company jets as business travel, while Chesapeake employees were doing millions of dollars’ worth of personal work at McClendon’s home. He had put longtime friends on the Chesapeake board and showered them with compensation. He maintained personal stakes in company wells and used these as collateral for $1.55 billion in loans; at the same time, he was borrowing money from a company board member and running a private two hundred million dollar hedge fund from Chesapeake offices.⁵

Disgrace couldn’t keep Aubrey McClendon down for long. Since his formal departure from Chesapeake Energy, he has formed a new company called American Energy Partners, with headquarters down the street from his old Chesapeake office in Oklahoma City.⁶

Clearly, not all oil and gas companies specializing in fracking mimic Chesapeake’s extravagance and opacity. However, if the analysis in Chapter 3 is even approximately correct, then the shale industry is on shakier ground than many believe. Perhaps the fracking companies’ business model simply reflects the problematic nature of the resources they pursue, and the price and investment structures needed to get those resources out of the ground and to market.

Chesapeake and other shale gas and tight oil companies have made extravagant claims about how communities, households, and the nation as a whole benefit economically from fracking. There’s no question: a lot of money has changed hands as a result of shale gas and tight oil development during the past decade. Billions of dollars have been spent in drilling, and billions have been returned in sales of oil and gas. In this chapter, we’ll try to answer the question: Who really benefits?

COMMUNITIES

The boomtown syndrome is as old as the petroleum industry itself. Once commercial deposits of oil or gas are confirmed, drillers and speculators arrive by the truckload, driving up prices for just about everything. Prostitution and motor traffic proliferate; peace and quiet disappear. Years later, after local citizens have spent their money from drilling leases, the oil or gas begins to peter out. High-paid workers leave town, and the local economy deflates.

This predictable syndrome tends to characterize fracking operations even more than conventional oil and gas development, because shale gas and tight oil per-well production rates tend to decline so steeply (making the boom briefer and the decline steeper), and also because damage to the environment and to local roads, public health, and community solidarity can be much more serious.

Here is a typical assessment of the economic boon from fracking, lifted from an industry-funded website:

Hydraulic fracturing has . . . boosted local economies—generating royalty payments to property owners, providing tax revenues to the government and creating much-needed high-paying American jobs. Engineering and surveying, construction, hospitality, equipment manufacturing and environmental permitting are just some of the professions experiencing the positive ripple effects of increased oil and natural gas shale development.”⁷

There’s definitely some truth here. Consider the example of Bradford County, Pennsylvania. In recent years its economy had been in decline as manufacturing jobs moved to China. But now, as Chesapeake Energy and other operators are fracturing the Marcellus shale beneath the county to release billions of cubic feet of natural gas, the economy is flourishing. The county has retired five million dollars in debt and has lowered real estate taxes by 6%. A Bradford County Commissioner has called fracking “an economic game-changer for the entire area.”⁸

However, studies that look at the bigger picture reach more nuanced conclusions. A report by the Keystone Center in Pennsylvania found that “the Marcellus Shale is making a small positive contribution to recent job growth in Pennsylvania.”⁹ New (and often temporary) jobs are being offset by damage to existing industries, including tourism and the Pennsylvania hardwoods industries. In Bradford County, cited above, the Pennsylvania Department of Environmental Protection has recorded upwards of six hundred environmental violations from fracking, and the consequences for farmers have been severe—including contaminated water, plummeting property values, and sickened livestock. Many farmers have simply given up in the face of these challenges. Meanwhile, Pennsylvania research has also found that many of the new jobs go to skilled out-of-state workers who fly in, drill, and fly home. The jobs for locals generated by fracking typically last for only about two to three years.¹⁰

All of this should be fairly predictable and unsurprising. Historically, regions that rely on resource extraction as an economic pillar often underperform when compared to other regions, especially when viewed over the long term. More wealth is typically created in places that use energy and minerals for manufacturing and trade than in ones where resources are mined. For example, coal areas in West Virginia continue to be pockets of poverty despite decades of mining activity. The long-term jobs created there often pay little, and other industries—including agriculture—are driven out by the ensuing environmental damage.¹¹

In both Pennsylvania and New York, drilling companies are moving into the poorest counties first—and not just because that’s where the shale resources are located. Economically struggling areas are often targeted because the locals are less likely to engage in anti-fracking activism. People who desperately need leasing money or temporary employment may be willing to overlook environmental damage, even if it impacts their own land and homes, and they can also be counted upon to take the industry’s side when community disputes arise over air or water quality.

Meanwhile, people subsisting on fixed incomes (such as elderly renters) who don’t receive income from drilling leases or truck-driving jobs may have to move out because they can’t afford soaring rents and food prices.

Local governments benefit temporarily from increased tax revenues during drilling booms. But costs to repair road damage—sometimes running into the millions of dollars—may outweigh that short-term bonus. In 2012, the State of Texas received about $3.6 billion in severance taxes from all oil and gas produced in the state (from conventional wells as well as those in fracked shale). But during that same year, the Texas Department of Transportation estimated damage to Texas roads from drilling operations at $4 billion. Arkansas has taken in roughly $182 million in severance taxes since 2009, but costs from road damage associated with drilling are estimated at $450 million. Roads designed to last 20 years are requiring major repairs after only 5 years due to the constant stream of overweight vehicles ferrying equipment and water to and from fracking sites.¹²

The influx of workers also puts pressure on schools and hospitals. Yet it makes little sense to expand these facilities permanently, given the temporary nature of drilling booms. Meanwhile, police have to deal with increased crime rates, including (in Colorado, for example) high rates of methamphetamine usage among drill crews.¹³

Disputes about fracking within communities can also strain the very process of democracy. When the city of Longmont, Colorado, enacted regulations to make residential neighborhoods, schoolyards, and the city’s open spaces off-limits to drilling, Governor John Hickenlooper sued, contending that more lenient state regulations took precedence. In response, Longmont citizens launched an initiative to ban fracking altogether within the city. Though overwhelmingly outspent by industry money, the ban initiative carried by a remarkable 60/40 margin. Industry, backed by the state, has sued to overturn the ban.

As Deborah Rogers points out in her report, “Shale & Wall Street,” the oil and gas companies “are not in business to steward the environment, save the family farm, or pull depressed areas out of economic decline. If these things should by chance happen, they are merely peripheral to the primary mission of the companies.”¹⁴ Yet the promise of benefits to communities helps these companies achieve their real primary goal—which is to extract hydrocarbons as cheaply and efficiently as possible and to sell them at the highest price that can be realized. Expectations of jobs and tax revenues can deter investigations into environmental and health problems, and delay regulations.

For communities that have endured environmental insults, human health impacts, and costs to road infrastructure, all for the sake of income from fuel production, it is perhaps the bitterest of ironies when oil and gas companies simply refuse to pay promised royalties. This is by no means standard operating procedure within the industry, but it does happen.¹⁵ To mention just one example: in 2012 Chesapeake Energy paid five million dollars in settlement of a lawsuit brought by Dallas/Fort Worth Airport over significant underpayment for gas produced from horizontal wells beneath airport property.¹⁶

THE NATION

In their many opportunities to testify before Congress, oil and gas industry representatives have repeatedly painted a glowing picture of how America is benefiting from expanded shale gas and tight oil development. Here is Daniel Yergin speaking on the topic of shale gas in 2011:

This abundance of natural gas is very different from what was expected a half decade ago. It was then anticipated that constraints on domestic natural gas production would result in high prices for consumers and the migration of gas-using industries—and the jobs that go with them—out of the United States to parts of the world with cheaper supplies. The United States was also expected to be importing substantial amounts of natural gas in the form of liquefied natural gas (LNG). That would have added as much as $100 billion to our trade deficit. None of that has occurred. Instead, the United States has become, except for imports from Canada, mostly self-sufficient. . . . Gas prices have fallen substantially, lowering the cost of gas-generated electricity and home heating bills. Several hundred thousand jobs have been created in the United States. Gas-consuming industries have invested billions of dollars in factories in the United States, something which they would not have expected to do half a decade ago—creating new jobs in the process. The development of shale has created significant new revenue sources for states—for the state of Pennsylvania and localities in that state, for example, $1.1 billion in revenues in 2010.¹⁷

All true. But the implication is that with expanded drilling we can expect much more of the same. Not so true.

As for tight oil and its impact on America’s petroleum production and imports, here is Yergin speaking to Congress in 2013:

Net imports of crude will continue to decline. . . . [W]e will see the Western Hemisphere, and North America in particular, moving towards greater self sufficiency. At the same time, the very large, technically advanced refining complex on the Gulf Coast—along with the shifting domestic product demand—will put the United States in the position to continue to expand exports of refined products. . . . [E]xpanded domestic supply will add to resilience to shocks and add to the security cushion. Moreover, prudent expansion of US energy exports will add an additional dimension to US influence in the world.¹⁸

The impression we are left with is that it’s all good news in the oil and gas world, and America should be cheering. Yet that’s far from being an accurate portrayal. What’s most objectionable is the reassuring sense of permanence that characterizes Yergin’s description of our national energy picture. Domestic supplies of oil and gas will increase . . . but for how long? A “prudent expansion” of US energy exports could only be based on the assumption that the current spate of growing production will continue for decades. Yet, as we have already seen, the EIA anticipates a peak in Bakken tight oil extraction in 2017. And if the analysis in Chapter 3 is accurate, US shale gas production will begin to taper off at roughly the same time.

The shale gas industry has touted natural gas exports as a way to improve the US trade balance. Indeed, despite the fact that the United States remains a net natural gas importer, gas export efforts are under way: Dominion Corporation will begin construction on an LNG export project at its Cove Point terminal in Maryland in 2014, with contracts for delivery to Japan and India; Cheniere Energy is converting its Sabine Pass LNG import facility in Louisiana into an export terminal; and United LNG has signed agreements with India for the long-term supply of LNG by way of its offshore Main Pass Energy Hub, also in Louisiana.¹⁹ Meanwhile, Congress is on board with LNG exports—presumably as a way to boost the nation’s foreign revenues.²⁰

But the industry’s actual motives have nothing to do with improving America’s balance of trade. Potential LNG importers in Japan, India, and China will pay upwards of $15 per million Btus for natural gas, while the American domestic price hovers around $4. The natural gas industry wants to export its product for one reason only: to get a better price. If American users want that same gas, they will have to pay more. LNG exports will drive up the US price of natural gas: it’s simple economics, and no one who has seriously looked into the matter claims otherwise.

The natural gas industry is doing everything it can to substantially increase US natural gas prices, yet the same industry claims low gas prices as a benefit of its practices. The cognitive dissonance inherent in this situation is perhaps lost on most casual observers, but not on the American chemicals industry and electric power utilities—big users of gas. Recall Daniel Yergin’s statement (quoted above) that “gas-consuming industries have invested billions of dollars in factories in the United States, something which they would not have expected to do half a decade ago—creating new jobs in the process.” Are those jobs about to go away as gas prices shoot back up? Will power generators that switched from burning coal to natural gas in order to take advantage of low gas prices now switch back to coal?²¹

Industry boosters like Daniel Yergin often cite jobs as one of the principal benefits to America from fracking. Yet, as we have already seen, fracking’s actual jobs record has been oversold. Industry-funded studies often include professions such as strippers and prostitutes in their totals of new jobs created.²² Jobs for actual oil and gas industry workers have accounted for less than one-twentieth of 1% of the overall US labor market since 2003,²³ according to the US Bureau of Labor Statistics, and where those jobs relate to fracking, they will gradually disappear as plays are drilled out and production declines.

In a research note for Capital Economics (April 2013), Paul Dales argued that the oil and gas boom has provided only a modest economic boost to the US economy in recent years:

Since June 2009 the volume of oil and gas extraction has risen by 24%. Over the same period the production of mining machinery has risen by 47% and the output of mining support services, which includes oil and gas drilling, has leapt by 58%. . . . But that rise explains only a small part of the economic recovery. Admittedly, it is responsible for a fifth of the 18.3% increase in overall industrial pro-duction. Given that the oil- and gas-related sectors account for only 2.5% of GDP, they have contributed just 0.6 percentage points (ppts) to the 7.6% rise in GDP.²⁴ [Emphasis in original]

Perhaps the biggest real impact of fracking on the nation is at the macro scale of energy policy. As a result not just of temporarily increased production, but also of exaggerations from the industry (and spokespeople like Daniel Yergin), the United States is failing to plan for a future in which hydrocarbons are more scarce and expensive; failing to invest sufficiently in renewable sources of energy, and in low-energy infrastructure such as electric light rail; and failing generally to do what every nation must in order to survive in a century of rapidly destabilizing climate—which is to reduce dependency on fossil fuels as quickly as possible. US politicians of every stripe end up adopting the attitude, “Yes, of course we should be reducing fossil fuel consumption in order to avert the worst climate change impacts—but with the prospect of energy independence, jobs, and economic growth all flowing from shale gas and tight oil, how could we possibly say no?”

Yet, as we have just seen, these promises are largely unrealistic. Meanwhile, the costs of continued oil and gas dependency, which will be borne mostly in the future, already constitute an invisible though mountainous burden, compounding daily.

Throughout, fracking boosters appear to maintain a Marie Antoinette-like attitude toward the American people, saying, in effect, “Let them eat hype.”

THE OIL AND GAS INDUSTRY

When we inquire who benefits from the fracking frenzy, the intuitively obvious answer is, “the oil and gas industry, of course.” Yet this may be a simplistic assumption.

Drilling companies have seen increased revenues as a result of shale gas and tight oil production. This is primarily true for the outfits that managed to lease land in the core areas of shale plays, where wells are more productive and profitable.

The industry as a whole has scored big in terms of public relations: the promise of plenty has largely shifted the conversation in America from worry about high energy prices, supply vulnerability, and climate risks, to ebullience over the illusion of “energy independence.”

However, as we have just seen, many shale gas (and some tight oil) operators in non-core areas have been losing money on production. Only a few companies are profiting handsomely. Clever operators can squeeze profits out of money-losing field operations with “pump and dump” stock schemes, selling stocks to gullible pension fund managers, or selling bundles of drilling leases (of highly variable quality) to foreign investors. A few early birds (such as Aubrey McClendon) have gotten spectacularly rich, while building financial structures packed with risk.

One of these risks consists of price volatility. Shale gas and tight oil production only makes economic sense when fuel prices are high. But (as gas drillers have learned, to their bitter disappointment) there is no guarantee that prices will stay high enough, long enough, for investments to pan out. If the US economy were to fall back into recession, energy demand would drop and so would oil and gas prices. Drillers would have no choice but to idle their rigs and accept losses.

Perhaps that’s what led Aubrey McClendon to say in an investor call in 2008, “I can assure you that buying leases for x and selling them for 5x or 10x is a lot more profitable than trying to produce gas at $5 or $6 mcf.”²⁵ Gas prices wound up dropping to less than $2 per thousand cubic feet (mcf).

Another risk comes from potential liability for environmental and human health damage. Producers try to contain risk with ongoing improvements to their procedures, but also with nondisclosure agreements. States and counties are increasingly restricting and even banning fracking out of concern for human and environmental health, and the result could be a sharp decline in potential revenues for operators—and therefore a drop in stock value and an increase in borrowing costs. A general lack of transparency in the industry makes it difficult to ascertain the total payments made to date for settlement of damage claims. But worries about declining water and air quality pose a growing public relations hurdle for the companies.

Still another risk comes from the very hype that drives investment toward the industry. When projects go sour, investors flee, and suspicion grows among the investment community that shale production is merely a bubble. This perception is bolstered by companies pulling out of shale plays or deciding against funding, for example, a pipeline to North Dakota—presumably out of recognition that volumes of crude produced will not be high enough, or last long enough, to make such a pipeline pay off.²⁶ It’s as though drillers are admitting they don’t believe the hype themselves.

Fracking is helping the industry as a whole bring more product to market. But the top international oil companies—ExxonMobil, Shell, BP, Chevron, and Total—have seen their overall production decline by over 25% since 2004.²⁷ Meanwhile capital spending by the industry has nearly doubled. The only factor forestalling economic bloodshed for the majors is high oil prices: while they must invest more upstream to produce fewer barrels, each barrel sold now brings in more revenue.²⁸

For a few players, the shale boom is a bonanza. Yet overall, despite protests to the contrary, evidence suggests the oil industry has entered its sunset years.

WALL STREET

If, in the final analysis, the nation as a whole and the impacted communities within it lose more from fracking than they gain, and the oil industry is seeing diminishing returns on its burgeoning investments, then who does stand to benefit?

In the Introduction and Chapters 2 and 3, we noted how, in many instances, gas prices have been driven down to a level below industry’s production cost. Low prices have in turn been cited as economic benefits of shale development. Yet aside from having gained a PR talking point, the industry itself has actually been hurt by low prices. Chesapeake Energy has not only reduced drilling, but sold off hundreds of millions of dollars’ worth of assets to cover unsustainable debt loads. BP has been forced to write off nearly two billion dollars in assets. Rex Tillerson, the CEO of ExxonMobil, told the Council on Foreign Relations in New York City in June 2012, “We’re losing our shirts [on shale gas production]. We’re making no money. It’s all in the red.”²⁹

Why did the industry shoot itself in the foot by overproducing shale gas? In some respects, the glut resulted inevitably from a land rush that occurred in the early years of the shale boom, when companies were leasing as much land as possible, as quickly as possible: the terms of drilling leases required drilling sooner rather than later, even if that meant oversupplying the market. But this is not a sufficient explanation for the price plunge. For a deeper understanding of the industry’s puzzlingly self-destructive behavior, we must follow the money.

In a New York Times investigative article (“After the Boom in Natural Gas,” October 20, 2012), Clifford Krauss and Eric Lipton wrote, “Like the recent credit bubble, the boom and bust in gas were driven in large part by tens of billions of dollars in creative financing engineered by investment banks like Goldman Sachs, Barclays and Jefferies & Company.” The article details how this “creative financing” forced drillers to keep drilling even when each new well represented a financial loss.³⁰

Deborah Rogers, a former Wall Street financial consultant and member of the Advisory Council for the Federal Reserve Bank of Dallas from 2008 to 2011, has further traced the toxic connections between major investment banks and shale gas/tight oil operators in her report, “Shale and Wall Street: Was the Decline in Natural Gas Prices Orchestrated?”³¹ She writes:

In order for a publicly traded oil and gas company to grow extensively, it must manage not only its core business but also the relationship it enjoys with its investment bankers. Thus, publicly traded oil and gas companies have essentially two sets of economics. There is what may be called field economics, which addresses the basic day-to-day operations of the company and what is actually occurring out in the field with regard to well costs, production history, etc.; the other set is Wall Street or “Street” economics. This entails keeping a company attractive to financial analysts and investors so that the share price moves up and access to the capital markets is assured. (p. 6)

It was “street economics” rather than “field economics” that drove the gas glut and price rout, according to Rogers, who notes that the price decline “opened the door for significant transactional deals worth billions of dollars and thereby secured further large fees for the investment banks involved. In fact, shales became one of the largest profit centers within these banks in their energy M&A portfolios since 2010.” (p. 1) She concludes that the glut was engineered in large measure “in order to meet financial analysts’ production targets and to provide cash flow to support operators’ imprudent leverage positions.” (p. 1) When natural gas prices tanked,

Wall Street began executing deals to spin assets of troubled shale companies off to larger players in the industry. Such deals deteriorated only months later, resulting in massive write-downs in shale assets. In addition, the banks were instrumental in crafting convoluted financial products such as VPP’s (volumetric production payments); and despite the obvious lack of sophisticated knowledge by many . . .investors about the intricacies and risks of shale production, these products were subsequently sold to investors such as pension funds. Further, leases were bundled and flipped on unproved shale fields in much the same way as mortgage-backed securities had been bundled and sold on questionable underlying mortgage assets prior to the economic downturn of 2007. (p. 1)

Wall Street benefits from manias—at least in the short term. Investment banks make money on sales of shares in companies whose activities spur speculative bubbles. They also profit from mergers and acquisitions when bubbles burst and companies go bust. For the most part, it’s not their money being invested—it’s more likely yours, if you have any kind of retirement account.

There are a lot of people benefiting from the shale gas and tight oil boom, ranging from drillers to landowners to hoteliers, but arguably none have profited more than investment bankers. And when oil and gas production falls and the fortunes of drillers, landowners, and hoteliers plummet along with it, the bankers will most likely continue to do just fine, thanks.

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