Will fracking save us all?

Donald Luskin has been called “the stupidest man alive” by UC Berkeley Economist Brad DeLong.  His recent pronouncements don’t do much for his case.  In an opinion piece in today’s Wall Street Journal Luskin and a colleague, Michael Warren, conclude that innovation in the fracking industry will continue at such a rate that shale oil will become “for all practical purposes, free.” He predicts that fracking companies will continue to become ever more productive through technological innovations that reduce drilling costs such that even at excessively low oil prices, fracking companies will reap ever expanding profits.

This conclusion is based on a cascading set of incorrect assertions –

1. Fracking companies are all the same.

In fact, the fracking industry is not the monolith he assumes. It ranges from big time shale operators like Harold Hamm’s Continental Resources, to the second largest oil company in the world – ExxonMobil – to a multitude of small operations that only operate in specific areas. Many of the small operators are heavily leveraged and even when making a profit can’t afford to keep the doors open and pay off their creditors. They are already going bankrupt in droves – like Dune Energy, BPZ Resources Inc., Endeavor International Corp., and Cal Dive International Inc. Just two months ago the largest operator in North Dakota, Whiting Petroleum, was being shopped to ExxonMobil and Continental. Well or decently capitalized companies will continue to produce oil at whatever margin is profitable for them, but heavily leveraged companies will go under or go on sale – particularly when Wall Street’s largess dries up.

2. Technological innovations have made fracking three times more profitable for companies at $65 a barrel then it was three years ago at $95 a barrel.

Three years ago, the fracking industry was in its infancy. Frackers were in the process of starting new companies and were shelling out big bucks for start up costs, equipment, personnel, and land rights – all at once. Starting a business is expensive. Even absent technological and managerial innovations, costs were bound to come down. This is a one time drop that can’t be expected to repeat.

3. Innovation produces exponential increases in profit.

Drilling for oil is not the same as producing a transistor. A one time claim that technological innovation produced an exponential increase in profits does not indicate a pattern.

4. “When you get more at-bats, you become a better batter.”

In other words, the more wells you drill means “increase[d] production and reduce[d] costs.” There is no indication that having to drill more wells – which is an inconvenience and an exceptional cost – is at all a benefit. Companies seek efficiency and cost cutting by limiting the number of wells they have to drill. Although companies gain expertise over years of experience, they would gladly forgo some of that experience for more productive wells the first time.

Even if these efficiencies do arise in the near future, it won’t even be “the American fracker,” necessarily reaping the benefits. The shale oil field is a complicated mess of participants and with so many companies highly leveraged and with tenuous market capitalizations, the companies drilling for oil now may not be the same ones piloting the horizontal drill bits three years from now.

BP, Shell, ExxonMobil, and even state-owned Saudi Aramco have all expressed interest in shale assets. Who is to say it will be American frackers expanding around the world and reaping the profits?