The economics of fracking

Andrew Critchlow writes in The Telegraph that, with crude prices slumping, Britain’s hoped for shale oil ‘revolution’ may be undermined by basic economics.


UK fracking faces bust amid Opec oil price war

Experts have warned that a rush to start fracking for oil across Britain may already be over before it has even begun as the slump in global crude oil prices makes the controversial method of drilling look increasingly uneconomic.

Bids from oil companies for licences to search and potentially drill for oil onshore in the UK are due on October 28. The auction of mineral exploration rights across vast swathes of the country will, it is hoped, spur a shale oil and gas “revolution” similar to that which has helped transform the US economy.

Hydraulic fracturing or fracking has made America increasingly energy independent and has broken its reliance on the volatile Middle East. The US, which pumps about 8.5m barrels per day of crude, is forecast to soon overtake Saudi Arabia as the top global producer of liquid petroleum.

However, the recent sharp declines in the price of oil traded on global markets – Brent is down around 25pc since hitting $115 per barrel in June – have cast a cloud of uncertainty over the process of opening up the UK to fracking due to the high costs associated with the process.

Fracking for so called “tight oil” involves the expensive process of cracking open shale rock formations deep underground and then pumping fluid and sand into the fractures under high pressure to force out the thick low quality crude.

The fear is that with the Organisation of the Petroleum Exporting Countries (Opec) – a group of 12 mainly Middle Eastern producers who pump a third of the world’s oil – apparently locked in a price war as each seeks to pump more crude than the market requires, it is the high cost of “tight oil” such as the projects being proposed in the UK that will suffer.

Recent research from Deutsche Bank speculated that if prices of Brent crude slump below $80 per barrel then almost 40pc of shale oil wells in North America could become uneconomic overnight. Although prices fluctuate, the German investment bank argues that relative to the US dollar a current “fair value” for Brent oil could be around $80 per barrels for a prolonged period.

“Investment decisions on future oil and gas developments in the UK have to be viewed in the context of the price over the next five years,” said a spokesperson for the trade body UK Onshore Oil & Gas.

Effectively, the embryonic shale oil industry in the UK finds itself caught in the middle of a global price war for control of energy markets. Although Opec countries need prices to hold at around $100 per barrel long term, analysts increasingly suspect that they are prepared to tolerate lower levels in the short term to counteract rising production in the US and even force some North American wells to shut down.

“We believe US shale oil activity could be increasingly sensitive to a falling oil price, particularly compared to Russian or Canadian supply because of the shorter drilling contracts in the US,” said Deutsche Bank’s strategist Michael Lewis.

However, in the context of the UK the breakeven cost of fracking is expected to be far higher, which might put off the major oil and gas companies that the Government wants to get involved and dissuade them from bidding in the current exploration licensing round.

“Fracking here is still in its infancy, but in North America a price range of $70 to $80 (per barrel) is seen as a challenging point for drillers,” Graham Sadler, the managing director of Deloitte’s Petroleum Services Group, told The Sunday Telegraph. “It’s hard to tell what the impact will be in the UK, but the cost of drilling would certainly be more expensive.”

Britain lacks any significant onshore infrastructure such as pipelines and processing facilities to handle a shale oil boom in the Home Counties. A study by the British Geological Survey of the “Weald” basin published this summer revealed that there were likely to be 4.4bn barrels of shale oil in the area, primarily beneath Surrey, Sussex and Kent. However, extracting this oil would be expensive when compared with the US due to the environmental considerations that will be imposed on drillers, experts say.

“It has to be more expensive,” Michael Tholen, the economics director for Oil & Gas UK told the Telegraph. “You can’t just plough up bits of Surrey and Blackpool like they can do in parts of the US.”

Despite these concerns, the Department of Energy & Climate Change (Decc) says that the licensing round – arguably the most important for the UK’s upstream sector since the opening up of the North Sea in the 1970s – is progressing regardless of the fall in oil prices and that it expects to award exploration permits early next year.

“We’re optimistic that there will be a strong response,” said a spokesperson for Decc.

However, most international oil companies approached by the Telegraph say they have no intention of bidding for onshore rights to explore in the UK anyway, given the more lucrative opportunities that are opening up elsewhere.

The British exploration auction coincides with Mexico – one of the hottest emerging fossil fuel producers – opening up its acreage to international oil companies for the first time.

Failure to secure significant interest from the industry’s blue-chip operators such as Royal Dutch Shell, BP and Chevron would be a blow for the Government, which hopes that fracking will compensate for declining production in the North Sea, provide long term energy security and boost the economy in the same way that can be seen in North America.

According to IHS Global Insight, shale gas production in the US will support nearly 870,000 by 2015 and contribute more than $118bn (£73bn) to the American economy.

It’s not just Britain’s nascent fracking industry that would suffer from a prolonged weakness in global oil prices. The North Sea – which has traditionally produced the vast majority of the country’s oil and gas – is vulnerable due to the high cost of production offshore and current taxation.

North Sea production is already under severe pressure from the rising cost of operating and the need to drill even deeper on the outer regions of the so called UK Continental Shelf. Output from the North Sea has slumped to around 800,000 barrels per day, a figure last seen in 1977.

Part of the problem has been George Osborne’s decision in 2011 to increase tax on drillers. The falling price of crude could now add to the crippling increases in cost that companies have had to endure offshore.

“A lot of projects that are currently being looked at are expensive. At $80 per barrel the more challenging projects don’t look as attractive as they once did,” said Mr Sadler.

According to Oil & Gas UK, there are about 150 projects offshore in British waters that are seeking investment and final sanction. These could be threatened if falling oil prices further erode the profits of drillers in the area, in addition to the higher tax burden they already face.

Oil companies working in the North Sea face handing over 81 pence in every pound of profits they make from the oil they produce, a figure that ranks UK production among the most heavily taxed in the world.

A consultation process on North Sea fiscal arrangements between the Treasury and the industry is currently ongoing and the Government is already coming under intense pressure to revise its current rules or risk a further decline in output, which is already down about 40pc over the last five years.

“The Government has squeezed the industry offshore for the last 15 years since oil prices started to rise,” said Mr Tholen. “The industry is frustrated, trying to keep old wells alive and get new stuff off the ground.”

Oil & Gas UK estimates that the North Sea will need a staggering £1 trillion of investment in order to recover all of the estimated 20bn barrels of reserves that remain untapped. Should oil fail to recover its recent levels of $100 per barrel and instead settle into a prolonged period of decline, then the Government will have to fund significant tax cuts and incentives to keep drillers working offshore.

To tap these reserves will increasingly mean oil companies must explore in frontier areas in deeper water. One such project that is being closely watched by the industry is the Rosebank field. Located 80 miles north west of the Shetland Islands, the field lies in water depths of 3,600 feet and will require a floating production, storage and offloading vessel. It is thought 240m barrels of oil could be recovered from the field, but the US oil giant Chevron which is investigating its viability has still to make a decision on whether to progress.

“A lot of companies think that North Sea investment opportunities look unattractive at around $80 (per barrel),” said Mr Tholen.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.