By Dr. Ali Dadpay, Assistant Dean-MBA Director, Associate Professor of Economics, College of Business, Clayton State University
The volatility of oil prices has encouraged technological advances, which have shaped the energy market. The catch is the 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 a new method 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 (fracking), as a well-stimulation technique using hydraulically pressurized liquid, became popular.
When oil prices were reaching the $150 a barrel benchmark, the marginal benefits associated with any additional production became immense. Thus, even a seemingly expensive method appeared to be a practical solution. Investors were encouraged by the promise of returns, guaranteed by high oil prices, and the industry convinced that it had to produce more oil.
Consumers knew they would need more and would like 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 U.S. oil dependency.
That is not all the 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 that, by cutting deeper fractures into the rocks to extract as much oil as possible, fracking is hazardous for the environment.
Fracking supporters keep arguing that its positive impact would not be truly measured as it has many indirect and induced effects on the economy. They pointed out how the local economies improved in North Dakota and Texas as fracking improved the oil production. It is remarkable to note that since 2011, U.S. oil production has increased by almost three million barrels a day. Last July, the total production reached 8.5 million barrels a day.
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 Arab Spring, the uncertainty lingering over Iran’s nuclear talks and the recent ISIL threat in Iraq and Syria.
However it must be noted that the increase in the supply of oil in the U.S. and Canada has been larger than any potential decline. So it is no wonder to see the oil prices are falling. The declining trend was further encouraged by the actions taken against ISIL. As the U.S. forces began attacking ISIL targets the market was assured that the risk premium in oil transactions remains unchanged.
Now the second part of story begins. As oil prices are falling and approaching $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 and 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 prices must be at least $90 a barrel. In their opinion fracking soon would be uneconomical. Some argue that if a price signal is defined for the environmental damage caused by fracking then fracking already is uneconomical. The fact is 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 1980’s and early 1990’s. No consumer returned to pre-shock days consumption patterns. In the years which 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, to start and to accept its implementation. Declining oil prices will not take away the fact that fracking is part of the market reality now. As oil prices decline many producers will remember 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 fracking in place, no matter what environmentalists say or how far below $90 a barrel the price of oil falls.