Memorandum submitted by Professor Paul
Stevens, Chatham House |
1. The "Shale Gas Revolution" in the USA
is part of significant recent developments in unconventional gas.
In addition to shale gas this also includes tight gas, coal bed
methane and also hydrates and biogenic gas. Unconventional gas
refers to the fact that simply drilling is not sufficient to produce
the gas as is the case for conventional gas. Further "activity"
is required and thus unconventional gas more resembles a manufacturing
process. The developments in shale gas have been achieved by
the application of horizontal drilling and hydraulic fracturing.
Neither are particularly new technologies to oil and gas but
they have been combined to good effect in recent years in the
USA. The results have been spectacular. In 2000, less than 1%
of domestic gas production in the USA came from shale; the latest
figures suggest it is now getting close to 20%. However, even
more important has been the impact on expectations. Up to 2005,
the general view in the USA was that domestic gas production in
the Lower 48 States would be in terminal decline. Given the continued
strength in gas demand, this implied growing imports of gas both
by pipeline but above all by the use of liquefied natural gas
(LNG). To that end a great deal of money was invested in the USA
in regasification capacity in the form of either taking regas
capacity out of mothballs or new build. Since 2000, such capacity
has increased ten-fold.
2. The "Shale Gas Revolution" has had a
huge impact in the USA. Gas prices have collapsed although this
has also been driven by lower gas demand as a result of the economic
recession. Thus based on data from the US Energy Information Agency
the average well-head gas price in 2005 was $7.33 per thousand
cubic feet (mcf) while the average for 2010 to October was $4.25
per mcf. Furthermore, LNG imports to the USA have collapsed and
in 2009 capacity utilization on regasification plants was less
than 10%. To put it crudely, a great many investors in LNG in
the USA have lost their proverbial shirts.
3. There can be no doubt that shale gas has the potential
to transform the global energy scene and is clearly a possible
"game changer". However, to determine whether this potential
can be realized requires the answer to two key questions: - Can
the "Shale Gas Revolution" continue in the US? Can it
be replicated elsewhere in the world?
Can the "Shale Gas Revolution" continue
in the US?
4. For the US there are several concerns. The current
low prices of domestic gas are threatening the economics of many
existing shale gas projects and future investment may well be
compromised. There are also the possible negative environmental
consequences of hydraulic fracturing. This involves injecting
water and chemicals at very high pressure into the gas plays.
The 2005 Energy Act explicitly excluded hydraulic fracturing from
the Environmental Protection Agency's Clean Water Regulations
- the so-called "Halliburton Loophole". As concerns
grow, drilling moratoria have been called on some shale plays
while environmental impact studies are completed. Interestingly
when in 2009 ExxonMobil bought XTO, the third largest gas producer
in the USA (mainly unconventional) for $41 billion, the deal had
a special clause that would invalidate the purchase if the government
(State or Federal) introduced legislation that was unfavourable
to hydraulic fracturing.
5. On balance it seems unlikely that the "Shale
Gas Revolution" can be halted in the USA. In particular,
in the last couple of years, the major international oil companies
have become increasingly involved. Such companies have much deeper
pockets and much greater influence with government than the smaller
companies who originally pioneered the "Shale Gas Revolution"
6. The answer to the second question about replication
elsewhere attracts much greater concerns, especially in the context
of Western Europe.
Can the "Shale Gas Revolution" be replicated
7. Potentially global unconventional gas resources
(coal bed methane, tight gas, and shale gas) are significant.
A National Petroleum Council Report in 2007 estimated unconventional
gas resources at five times conventional gas reserves. However,
the "Shale Gas Revolution" in the USA was triggered
by a number of favourable factors. It is useful to list these
and then consider in each case how likely replication might be
generally in a European context and specifically in the UK.
8.The shale plays in the US are larger, shallower
and more material than those in Europe. Furthermore there are
very large core samples available from earlier conventional drilling
in the USA. This creates much greater knowledge of the immediate
geology. There has been relatively little such drilling onshore
in Europe and hence the data are not available. A related problem
is that traditionally, exploration acreage being licensed in Europe
has tended to involve relatively small areas with fairly rigid
associated work programmes. Shale plays need larger areas and
greater flexibility to tease out the best prospects.
2. Tax Breaks
9. In 1980, the Crude Oil Windfall Profit Tax Act
in the USA introduced an alternative (non-conventional) fuel production
tax credit of $3 per BTU oil barrel. This was equivalent to 53
cents per thousand cubic feet (tcf). It remained in force until
2002 and was a significant incentive to attempt to develop unconventional
gas given that after 1980, the wellhead price rarely exceeded
$2 tcf. In Europe, only Hungary has any form of tax advantage
for unconventional gas.
3. Widely Dispersed Populations
10. Even ignoring environmental considerations, shale
gas operations are potentially very disruptive to local communities.
For example, on the Barnett Play in North Texas the average wellhead
density is 12 per sq km. In the USA, population density is very
much lower than is the case in Europe - 27 per sq km in the USA
compared to 383 in England. Furthermore, the population in the
USA has long experience (and acceptance of) oil and gas operations
in their "back yard". In large part this is because
property rights in the USA mean that shale gas operations (and
indeed any oil and gas operations) directly benefit the local
landowners. In New York State for example, some residents are
offered up to $5,500 per acre with 20% royalties on any gas produced.
In Europe, where subsoil hydrocarbons are the property of the
state, this is not the case. There is no reason for the local
population to accept the disruptions. This is reinforced because
given the capital intensive and specialist nature of shale gas
operations, there are few local employment benefits.
4. Easy Access to the Gas Grid
11. In the USA, access to the gas grid is based upon
"common carriage". This means any gas supplier can gain
access to the grid even if it is already operating at full capacity.
Other users must reduce their throughput on a pro-rata basis.
In Europe, access is based upon "third part access"
which means if the system is operating a full capacity there is
no access unless dedicated new pipelines are built.
5. Limited Environmental Control
12. In the USA, environmental controls in the context
of hydraulic fracturing were (very surprisingly) lax. In Europe
this is not the case and satisfying environmental impact assessment
criteria is likely to prove difficult and controversial. Already
local groups within the UK opposed to shale gas operations are
beginning to form as my Email inbox can attest. There is another
regulatory problem in Europe. European petroleum legislation
has no mention of unconventional gas which means it is not at
all clear how the industry will be regulated and on what basis.
My understanding is that, for example in Germany, unconventional
gas comes under coal mining legislation. A further difference
concerns access to water. This is key to being able to mount
hydraulic fracturing operations. In the USA access is generally
very good in the shale play areas. However, in parts of Europe
(notably in Central Europe where much of the European shale gas
resources are located) water access is constrained.
6. Service Industry Capability
13. Small entrepreneurial companies with the help
of an already vibrant and competitive service industry drove developments
in shale gas in the USA. For example, at the peak of the recent
boom in the Barnett Shale Play in 2008, 199 rigs were in action.
However, as of July 2010, there appeared to be only around 34
land rigs in the whole of Western Europe, compared with some 2,515
active land rigs in the United States in 2008, of which 379 were
in oil and 1,491 in gas. Putting it simply, the infrastructure
in Europe does not currently exist to mount enough unconventional
gas projects to make a difference. Of course this can change if
the projects appear profitable, but it will take time. However,
a further problem is that the service industry in Europe is an
oligopoly dominated by a few (largely American) companies. This
is not conducive to the rapid development of a service industry
14. For all of these reasons, the replication of
the "Shale Gas Revolution" in Europe and indeed the
UK faces a great many barriers. Of course, these are by no means
insurmountable but it will take time to manage them. Outside of
Europe, the story may be different. In particular, there are
parts of the world such as China were local opposition, which
forms the major source of barriers to shale gas development in
Western Europe, is likely to be "managed" quite easily.
15. There are many uncertainties associated with
the answers to the two key questions - can the "Shale Gas
Revolution" in the USA continue and can it be replicated
elsewhere. This is extremely important for the future not just
of gas markets but also the global energy scene. Uncertainties
over the answers to the questions will inhibit future investment
in gas supplies. There are already signs of the cancelation or
postponement of gas export projects such as the giant Shtokman
field in the Barents Sea north of the Kola Peninsula - a joint
venture between Gazprom, Statoil and Total. There are also serious
questions over the prospects of other gas projects such as Nabucco.
16. If the "revolution" does continue and
extend to the rest of the world, consumers can anticipate a future
floating on large clouds of very cheap gas. However, if it falters,
in the medium term, the world will face serious gas shortages
given these current investment uncertainties. As the world recovers
from global recession and as earlier constraints on gas use erode,
gas demand will grow. The UK provides an excellent example of
what happens to energy markets when previous constraints on gas
use are removed. In 1990 when the constraints began to weaken,
natural gas accounted for 20% of the UK's primary energy mix.
Only ten years later in 2000, gas accounted for 40% of primary
energy in the UK.
17. However, given the investor uncertainty described
above, future gas supplies will be lower than required had the
"Shale Gas Revolution" and its current hype not happened.
If unconventional gas fails to deliver on current expectations
- and we will not be sure of this for some time into the future
-in ten years or so, gas supplies will face serious constraints.
Markets will eventually solve the problem as higher prices encourage
a revival of investment. However, given the long lead times on
gas projects, consumers could face high prices for some considerable
18. A related problem concerns investments in renewables.
There is general agreement that the world must move to a low carbon
economy if climate change is to be managed. Among other things,
this requires much greater investment in renewables. In a world
where there is the serious possibility of cheap, relatively low
carbon gas which could be seen as a "transition fuel",
who will commit large sums of money to expensive renewables to
lower carbon emissions? Again, if shale gas fails to deliver,
it condemns us to a higher carbon future than would otherwise
have been the case.
UK GOVERNMENT IN
19. A key issue for the UK government is therefore
what might be done to try and reduce the current uncertainties
and thereby encourage greater investment in gas supplies generally
and shale gas in particular? Before providing an answer it is
necessary to argue why government should intervene at all? Why
not simply leave it to the market? This has been the European
Commission's position. On 19 July 2010, the European Commission's
Michael Schuetz of the Directorate-General for Energy was asked
how the European Union might assist in the development of shale
gas in Europe. He replied that it was not the EU's job to nurture
the technology, adding that "the industry has to develop
this business". The conventional argument for government
intervention is to manage market failure. Market failure arises
from a number of causes. These are conventionally listed as: imperfect
competition; inadequate information; the existence of externalities;
and finally the presence of public goods. Gas markets in Europe
are riddled with externalities most obviously in the context of
security of supply and monopoly tendencies. However, for shale
gas two specific issues stand out which justify government intervention
- the nature of the learning curve and the issue of contestable
20. A major problem with shale gas is that the plays
and indeed the wells on the same play are all very different in
terms of geology, well behaviour and reservoir characteristics.
Thus unlike many other activities, there is a very limited aggregate
learning curve. Thus research and development (R & D) are
essential ingredients to develop shale operations, as is the sharing
of information between operators. In the USA this process has
been going on over the last 10 years and has helped to reduce
shale gas production costs by moving down the learning curve.
However, because of the heterogeneity of shale operations this
experience cannot necessarily be applied in Europe without adjustments.
Traditionally, government should intervene to encourage and promote
R & D and the exchange of operating experiencing within the
limits of what is feasible given competitive advantage and commercial
21. In the theory of contestable markets, market
power such as monopoly can be controlled if there is threat of
entry. Actual entry of competing suppliers is not necessary;
simply the threat that the market might be contestable and new
suppliers might enter is sufficient to enforce behaviour associated
with competitive markets. Western Europe at the moment looks
as though it will become increasingly dependent upon gas imports.
If there are real prospects of significant gas supplies from domestic
shale sources, this could have a very powerful influence on the
behaviour of Europe's current external gas suppliers forcing them
away from seeking higher prices. Thus even if the UK government
and the EU only spout rhetoric about encouraging shale gas, this
might be sufficient to create a contestable market to contain
suppliers' behaviour over prices and contracts.
There are a number of actions that could be taken
by the UK government to encourage the development of shale gas
both here and in Western Europe more generally:
22. First would be to persuade/pressure the EU
to take a more positive proactive role in encouraging shale gas
developments. Western Europe is a regional gas market of which
the UK is an integral part. Therefore anything that increases
supply and reduces price will benefit the UK. The current EU position
on shale gas of "leave it to the market" is a serious
mistake that ignores the externality dimensions involved. At the
very least this pressure could involve looking at the myriad of
European regulations which might inhibit shale gas developments.
23. The government could do much to encourage
R & D into shale gas. This could range from the funding of
research and a research centre to ensuring operating experiences
are shared between companies to try and create an aggregate learning
24. Something must be done to sort out the regulatory
uncertainty with respect to shale gas. There needs to be explicit
regulation to bring shale gas operations into the general petroleum
legislation. In particular, to allow for much more flexible terms
for licensing acreage such that the work programme associated
with shale plays can be better managed.
25. Given the positive externalities associated
with shale gas in the context of security of supply - mainly the
contestable market argument developed above- there may be a case
for subsidy or at least some form of tax break/credit on shale
26. Clarify the environmental position on hydraulic
fracturing by ensuring the results of the current studies underway
in the USA are disseminated. At the same time it will be necessary
to carry out environmental impact assessments of shale gas developments
in the UK to consider the relevance of the operating conditions
to the experience in the USA.
27. Introduce financial mechanisms such that
local communities can be compensated for disruption by some sort
of fund drawn from the operators. This could be some form of compulsory
corporate social responsibility fund. Something is required to
provide incentives for landowners to allow access and communities
to accept disruption.
28. Tax breaks for drillers building new rigs
could also encourage the development of a European service industry
that would make a shale gas revolution in Europe a more likely
possibility. At the very least, there should be efforts to ensure
that importing shale gas technology from the USA -software and
hardware - is not constrained although the encouragement of a
home grown service industry is preferred.
12 For further information on all of the preceding
discussion see my report: The "Shale Gas Revolution"
Hype and Reality. http://www.chathamhouse.org.uk/research/eedp/papers/view/-/id/947/