Winter 2014

Shale: The New US Frontier

Philip Delves Broughton

When historians look back to the Obama Presidency, the stand out economic feature will not be the Great Recession and its aftermath. It will be the staggering growth in domestic oil and gas production. Not since the oil embargo of the mid-1970s, when the United States doubled down on securing the global energy supply emerging from the Middle East, has there been such a change in the relationship between energy and American power. 

In 2000, the United States supplied just 2% of its natural gas consumption. By 2012, the discovery and extraction of vast reserves of shale gas meant it could now supply 40% of its own consumption. The shale gale” has turned the US into the world’s top producer of natural gas, surpassing even giants like Qatar and Russia, and within four years it is expected to be a net exporter of liquefied natural gas. Next autumn, the first LNG exports from the lower 48 states will start to leave from Cheniere Energy’s Sabine Pass liquefaction facility in Louisiana. More than 20 other companies have been permitted or are applying to export American LNG

Since the 1976 oil embargo, the United States has spent an estimated $8 trillion patrolling the Strait of Hormuz to guarantee the passage of Arabian oil to the global market. Now, more than 80% of that oil is being shipped to Asia. In the meantime, the volume of US imports of crude oil has fallen back roughly to where they were in the mid-1990s. It now imports just 30% of its supply compared to 60% in 2006. Its domestic production has risen to its highest level since 1989, thanks to the release of previously inaccessible tight oil” reserves. 

Long after the bank bailouts of 2008 are forgotten, the Marcellus and Bakken shales, the two largest and most productive of America’s new found reserves, will still be keeping the lights on and America’s homes and factories humming. 

Generations of American diplomats, economists and warriors have grown up seeing energy security as the best proxy for that more ambiguous term, national self-interest. Energy needs have been a major factor in America’s diplomatic and military investments in the Middle East and Latin America. A new energy war is now shaping up in Europe, where Russia is using its resource power to influence is former Soviet neighbors and to threaten the EU

The contours of this new global framework remain fuzzy and the United States is still figuring out a new code of domestic and global conduct appropriate to its burgeoning energy potency. 

Democrats have never been seen as the party of fossil fuel energy, but without the new production chances are President Obama would be overseeing a much flatter economy. The fastest growing state economy these days is in North Dakota, home to much of the new production, which grew at nearly 10% last year. Two other energy rich states, Wyoming and West Virginia came second and third. The abundance of cheap, domestically produced natural gas is luring manufacturers back to America from countries like China, where other input costs, notably labour, are rising. 

As for the consequences on foreign policy, opinions are wildly divided. On one extreme are those who hope that America will seize this chance to become energy independent”, and return to some pre-World War One state of neutrality and abstention from the rest of the world. In this scenario, America keeps the energy it produces for itself, keeps gas prices and manufacturing costs low, and restores its economic super-powers while cutting back on its political ones. 

At the other extreme are those who see America’s newfound energy as a fresh source of global diplomatic power, a way of stripping power from political foes, such as Russia and Venezuela, and awkward allies in the Middle East. Instead of sending armies to police the world, America can now police it with its abundant energy supplies. 

Either way, a middle-aged White House is feeling the surge of all this energy Viagra. Last year, Tom Donilon, President Obama’s then national security advisor, told an audience at Columbia University in New York America’s new energy posture allows us to engage from a position of greater strength. Increasing US energy supplies act as a cushion that helps reduce our vulnerability to global supply disruptions and price shocks. It also affords us a stronger hand in pursuing and implementing our international security goals.” 

The practical implications of this stronger hand” have been seen in the administration’s handling of ISIS in Syria, and Iran over its pursuit of nuclear weapons. In this new world order of American energy abundance, the United States can enforce economic penalties against its resource-rich enemies in a far less timid way than in the past. Its planes have bombed Syrian refineries controlled by ISIS in order to limit the organisation’s funding. It has tightened the sanctions noose around Iran by pressing major importers such as China and Europe to stop buying its oil. Official US estimates are that Iranian oil exports have fallen by one million barrels a day, and its revenues from oil and gas exports have halved in the past two years. In an era of oil scarcity, this might have had a calamitous effect on global prices and supply. Not any more. 

But the most visible example of America’s new shale-powered foreign policy is in its handling of Russia. Ever since January 2009, when Gazprom turned off the gas flowing into Ukraine in a dispute over unpaid bills, Europe has been hurtling as fast as it can away from dependency on Russian energy. Germany now receives most of its Russian gas via Nord Stream, a dedicated pipeline running beneath the Baltic Sea from Vyborg to Greifswald. But it is also pressing ahead with its remarkable attempts to simulate innovation, adoption and eventually lower prices in renewables, which now produce nearly 30% of Germany’s electricity consumption. The EU’s Third Energy Package, adopted in 2009, sought to unbundle energy generation and transmission and ensure that Russian gas, once in Europe’s pipeline infrastructure, can be routed among members as required and not subject to Gazprom’s monopoly power. 

Across Europe, governments are looking to North Africa, to Israel’s hugely promising Tamar gas field, to the established gas fields of Qatar, and newer prospects in Australia and Mozambique. In this context, the American gas boom could not have come at a better time. 

During the most recent crisis in Ukraine, members of Congress asked why the United States did not simply start sending gas to Europe to relieve it of its reliance on Russia. In one sense, it already is. The gas and oil the United States no longer has to import is now available to the rest of the world. The market in both commodities is deeper thanks to the US production boom, even before the US exports a drop of oil or LNG

But the idea that the US can now resolve all the world’s energy problems at a stroke is wildly mistaken. There are rarely quick answers in energy. A surge of optimism today can be met by a crash in commodity prices tomorrow. Exploration and infrastructure take years to bear fruit. You cannot raise the money to develop a pipeline or re-gasification facility the way you can for an iPhone application. Consumer technologies, such as cars and home heating, need to adapt if the new supplies are to find demand. 

For all the will in the world, the United States cannot, on a dime, flood Europe with natural gas. The infrastructure does not yet exist to ship liquefied gas in anything like the volumes required from the US and then re-gasify it in Europe. On-shore import facilities take years to be permitted and built. The urgency of Europe’s situation, particularly eastern Europe’s reliance on Russia, is driving investment in floating, off-shore facilities which can be built more cheaply and quickly. But even these take time. 

There is, however, a longer game to be played regarding gas that revolves around the twin forces of pricing and technology. 

Unlike crude oil, which is priced off a single index, natural gas has two pricing systems. The first is the Henry Hub price, a spot market price for American natural gas named after a distribution hub in Louisiana. This trades up and down like any other commodity and for the past year has moved in the $4-$5 range, per Million Btu. Russian natural gas, however, is indexed to the price of oil and has spent most of the past year at around $10 per Million Btu. Asia currently pays another 50% or so over the indexed price to compensate for higher transportation costs. 

Russia is the leading voice in the 13-member Gas Exporting Countries Forum, a weak attempt to create a gas version of OPEC. The GECF includes Qatar, and several African and South American exporters, but neither the United States or Australia, which is gearing up to be a mighty exporter in the near future. Vladimir Putin has turned the GECF into a kind of Axis of the Indexed, defending higher prices and long-term contracts for gas on the grounds that it allows for security, stability of supply and investment in pipeline infrastructure. 

But as more LNG travels by tanker, it will become harder for the indexed prices to hold versus a price set by a growing global market. The longer Russia continues to step on the hose of natural gas supply, the more likely it will find itself blown away by the Henry Hub. The greater transparency of a real market price, when it does become universal, will stimulate competition and private investment, and expose the most inefficient producers. 

The second important factor will be technology, in exploration, transportation and consumption of natural gas. We have already seen the potential of new, American-led technologies to extract shale gas and tight oil, and advances in deep-sea drilling. But we are still at the foot of what looks to be a long learning curve. For now, there is vocal and politically influential opposition to hydraulic fracturing, fracking”, a process for extracting shale oil and gas. The US government has investigated the process and found it to be acceptable, but the best long-term outcome will be for less controversial extraction processes to be found. 

At the consumption end, America’s coal-fired power stations are already being replaced by natural gas stations to provide electricity. If there is a real shift to electric cars, with the consequent rise in demand for electricity, then natural gas could overturn oil’s long dominance in powering America’s auto fleet, and consequently the world’s. This change could be years off, but it does feel like it is coming. 

There are myriad ways to make and lose fortunes in the energy businesses, particularly when its fundamentals are shifting as dramatically as they are now. We know that there is abundant natural gas in the world, which can be extracted at different levels of cost. But there are strong, competing forces at work that will dictate supply and pricing in the future, and justify or postpone investments today. 

The first is economic growth in non-OECD countries. The second is the increased efficiency of extracting and using natural gas. And the third is the growth in renewable sources of energy. The first driver evidently will increase demand over time, while the next two will tamp it down. 

Goldman Sachs recently predicted that while worldwide demand for LNG will grow at a compound rate of 5% by 2020, oversupply will lead to the delay or cancellation of major gas projects around the world. The price of gas from Marcellus Shale has fallen by nearly 70% since 2008. The US Department of Energy has issued permits to export nearly 10 billion cubic feet of natural gas each day, roughly two thirds of what Russia exports to the European Union a day. As that starts to hit the global market, prices of gas around the world should fall. 

All of the energy majors are being forced to re-examine their investments in natural gas based on fears that expensive exploration and drilling projects will be undermined by excess supply and a long era of low prices. This has left a gap in the market for smaller players, which can experiment and innovate in very different ways from the majors. It remains for now a wildcatters’ market. 

A first wave of American land grabbers including Chesapeake, Devon and Anadarko made fortunes signing drilling leases across the rich shale regions of North America, which they have since sold to bigger players or are exploiting themselves. The first permitted exporter from the lower 48 states is Cheniere, a relatively small company that first built an import facility before the shale gale, then converted it into an export facility with private investment. It trades under the ticker LNG, and has been a hedge fund favourite as its share price has doubled over the past year and risen tenfold over three years. Israel’s Tamar gas fields are being tapped not by any of the majors, but by several Israeli companies and the Texan independent operator Noble Energy. 

Like so many commodities, natural gas can drive people’s expectations to the highest highs and lowest lows, ignoring the powerful underlying trends. A fast-developing world is going to need more fuel of whatever kinds are available. Gas is cheap and increasingly abundant, in places that don’t have to be guarded with fleets and armies, notably America. We are getting better at finding it, getting it out of the ground, transporting it and using it. Environmental concerns may yet knock its progress off course. From an American perspective, the shale gale has already tilted the world on its axis, and the full consequences are only just emerging. 

Philip Delves Broughton is an author and journalist. He is a Senior Consultant to Brunswick, based in New York. He was previously a Senior Adviser to the Executive Chairman of Banco Santander. His books have appeared on The New York Times and Wall Street Journal bestseller lists and been published around the world.