The volatility of oil prices has encouraged technological advances that have shaped energy markets. The catch is that new techniques remain in place even when oil prices decline. The same may be applicable in the case of fracking. It has increased oil production while reducing the energy market risk premium.
As oil prices were increasing during 2001 to 2008 the industry came up with new ways to increase production. The economic rationale was one of marginal analysis. If the marginal benefit of the increase in the production is larger than the marginal cost associated with it then it can be used. Thus hydraulic fracturing, as a well-stimulation technique using hydraulically pressurized liquid, became popular.
When oil prices were close to $150 the marginal benefits associated with any additional production became immense. Thus even a seemingly expensive method appeared to be a practical solution. The investors were encouraged by the promise of returns, guaranteed by high prices, the industry was convinced that it had to produce more oil while consumers knew they would need more but prefer to pay less at the gas stations. The industry soon utilized fracking on a national scale. The increase in oil production caught everyone by surprise, even though it was expected. Today many credit fracking with reducing US oil dependency.
That is not the whole story. First in any marginal analysis both sides argue that many hidden costs and hidden benefits were not taken into account. Those who criticize fracking believe by cutting deeper fractures into the rocks to extract as much oil as possible fracking is hazardous for the environment. Advocates keep arguing that its positive impact would not be truly measured as it has many indirect and induced effects on the economy. They point out how the local economies improved in North Dakota and Texas as fracking improved oil production. It is worthy of mention that since 2011, US oil production has increased by almost 3 million barrels a day. Last July the total production reached 8.5mbd.
It is Economics 101: when supply increases then the equilibrium price falls and the equilibrium production increases, if all other things are constant. It is true that the oil market has been interrupted by the so-called Arab Spring, the uncertainty over Iran’s nuclear talks, and the recent IS threat in Iraq and Syria.
However it must be noted that the increase in the supply of oil in the US and Canada has been larger than any potential decline. Small wonder that the price of black gold is of a descending order. The declining trend was further encouraged by the actions taken against IS. As the US forces began attacking the radical militants the market was assured that the risk premium in oil transactions remains unchanged.
Now the other part of the story. As oil prices take a beating and fall below $90 a barrel many ask if fracking is still economically feasible. Declining oil prices are translated into lower marginal benefits for oil produced through fracking. As the marginal benefits diminish if the marginal cost increases or remains unchanged then there is a price beneath which fracking is no longer feasible. The debate is raging over what this price level is.
Many argue that for oil producers to break even using fracking the oil must sell at least for $90 a barrel. In their opinion fracking would soon be uneconomical. Others say if a price formula is defined for the environmental damage caused by fracking then it already is uneconomical. The fact remains that the industry is using fracking and it seems it will continue to use it.
Both groups forget one historical fact. Fracking is not the first technique employed by the oil and natural gas industries in a time of despair. During the oil shock of 1970s many industrial countries faced recession. Right away, they implemented measures to harness the growth of demand and to increase oil production. Oil prices began to fall before the end of that decade. The trend was invigorated as supply was increasing as well. The prices fell further to reach an all-time low during late 1980s and early 1990s. No consumer returned to pre-shock days consumption patterns. In the years that followed OPEC oil ministers spent a good deal of time deciding the output level and complaining about others. It was a new oil industry and a new market reality.
The same can be said of fracking these days. Rising oil prices provided all stakeholders with the necessary incentives to allow, start and accept its implementation. Declining oil prices will not take away the fact that fracking now is part of the market reality. As oil prices decline many producers shall recall that fracking is more than just another technique. It has insured the energy sector against the volatility of the Middle East and the impulsiveness of some exporters such as Russia. Its existence means a more stable market and a smaller risk premium for oil and natural gas industries. For some that is enough to keep on fracking, no matter what environmentalists say or how far below $90 a barrel the price of oil falls.
Ali Dadpay is associate professor of economics at Clayton State University, US.
