Category Archives: James A. Gibbs

The Changing Face of U.S. Exploration

I recently heard a speech by the chairman of a large financial institution that provides funds to oil and gas companies drilling wells in the U.S.  The primary theme  of his talk was that “petroleum exploration is dead in the United States. We know  where all the oil is now, and the industry’s job is just to learn to get it out more  efficiently and profitably.”

As a geologist who’s spent a long career exploring for oil and natural gas, his  statement struck me as naively shortsighted.  I’d never considered that all our  nation’s oil fields might already have been discovered, and that nothing is left for  oil and gas explorers to do but pack up the maps and retire to their basements.

After all, within the last three years, two friends, Jim Musselman, president and  CEO of Caelus Energy in Dallas, and Bill Armstrong, president and CEO of Armstrong  Oil and Gas in Denver, have each discovered new oil fields that are the largest found  in the U.S. in 30 years.  Situated on Alaska’s North Slope, each of the fields is  expected to yield more than a billion barrels of oil, and both Jim and Bill say they  believe many more fields are waiting to be discovered in the state.  I’m certain  neither expect their new discoveries will be their last.

Both new fields were found by “conventional” methods:  i.e. utilizing inferred  models of geological “traps” where oil could be contained, then drilling vertical  wells to test their ideas.  For more than a century, oilmen and women have  employed a variety of geological theories, methods and technologies to explore for,  find and produce oil from the now?known fields around the world.
 
About a decade ago, the combined technologies of horizontal drilling and hydraulic  fracturing  (“fracing”)  made  possible  the  drilling  and  production  from  rock  formations previously known to contain hydrocarbons but thought to be too dense  or “tight” to yield them in commercial quantities.  Oil and natural gas produced  from this new resource base are known as the “unconventionals”.

Consequences  of  the  “unconventional  revolution”  have  been  profound.  The  technologies have opened vast areas of the U.S. and around the world as new  targets for drilling.  For the U.S., 2009 ended an annual decline in oil production  that dated back to 1971.  Since then, a steady annual increase in daily production  will allow the U.S. to reach or exceed 1971’s peak this year.  In doing so, the industry 
has employed thousands of new oilfield workers, decreased our reliance on foreign  and often adversarial countries to make up our petroleum shortfalls, decreased our  negative balance of trade deficits, and enhanced our nation’s security and influence  abroad.

For the oil industry, the unconventional revolution is changing the nature of the  business  from  exploration  to  exploitation.  In  the  past,  most  wells  and  field  discoveries were made by independent operators and small companies, who sold  their holdings to larger companies to develop and exploit.  Today, because “tight  rock” shales and fine?grained siltstones are more tabular in form and wider in  distribution  than  “conventional”  reservoirs,  finding  productive  zones  is  more  predictable, and thus is less risky than “wildcat” tests.  Greater predictability has  attracted billions of dollars to develop these “resource plays”, commonly by new  companies, venture capital firms and investment groups, for whom investors funds  are readily available.

In this new regime, the role of the independent geologist or small?time operator  has been greatly diminished.  Prices of oil and gas leases and expenses of horizontal  drilling, well completions, lease equipment and operations have all soared.  The  technical knowledge and expertise required to drill most wells today are well  beyond that of past generations of “mom and pop” operators.

As a result, conventional oil and gas exploration has been in a decline for the past  five years, with the number of exploratory wells down more than 60%.  Last year,  the  total  number  of  conventional  discoveries  was  the  lowest  since  1952.   Discoveries, once the backbone of reserve replacement, have failed to replace  production  for  the  past  eighteen  years.  Since  2014,  companies  have  cut  exploration  spending  by  47%,  or  close  to  $1  trillion,  with  many  companies  completely shutting down their exploratory drilling.

Bygone years when an exploration army of would?be J.R. Ewings was active may be  on the way to ultimate oblivion.  But so long as individuals with knowledge,  initiative, and burning desire to find new million?barrel fields are around, my bet is  that some will.  We anticipate that many new fields and producing areas will be  discovered by individuals conducting exploration activities.        

Rules of the Road

This year begins the thirty-third year of business for Five States Energy Company. Some of our early investors have been participating with us almost as long, and continue to join us in new offerings of partnerships and funds.

When Don Malouf, Arthur Budge, Jr. and I organized Five States in 1985, we agreed to be guided by several principles for the business to which we have attempted to adhere through the years. With Don’s passing, we reflect back on these tenets with renewed commitment to continue the company as we believe he would have wished.

Plan for the future with a long-term investment outlook.

From the inception of Five States, our primary goal has been to accrete wealth for ourselves, our families and our investors through the acquisition of high-quality, long life, income-producing oil and natural gas properties to be held for income generation.  We manage the business conservatively, with an investment horizon of years or decades, rather than months.

Put the interests of our investors ahead of our own.

We’ve built our business on the concept that we’re successful only if our clients and investors are. To date most of our investments are structured as “back in after payout”, i.e. investors receive 100% of invested capital before Five States receives promotional benefit. The result is that Five States and investors have common objectives from the start: to recover investment capital as soon as possible, so that payout occurs quickly. Everyone benefits from low overhead and expenses charged against revenue.

Maintain significant ownership of the company.

Ownership in Five States is the principal personal asset of the Managers. Managers own a large percentage of the company, and have personally invested in every investment opportunity offered by the company since 1985. We “eat our own cooking”, and believe our investments and those of our clients and investors to be successful and profitable.

Manage the business with integrity, with quality business partners.

Integrity of the people we deal with, including employees, brokers, business associates, clients and investors, is of upmost importance to us. Prior to entering into a financial transaction of any kind, we strive to know as much as possible about the record and reputation of the persons with whom we’re to work. It’s usually the first step in our analysis of any proposed project.

Provide timely transparency in company and investment affairs.

We’d like our investors to be as knowledgeable and informed about their investments as possible. We try to make our offering documents, quarterly and annual reports, and correspondence comprehensive and clear, and we welcome questions about the company or investments at any time.

Enjoy the ride.

At the inception, Don, Arthur and I believed that a well-run oil and gas company, committed to long term objectives of acquiring and managing high-quality oil and gas properties, could be an interesting and fun experience. It has been!  Although Arthur and I will greatly miss Don, neither Arthur nor I have thoughts of doing anything other than continuing to enjoy our activities, our loyal employees and a host of wonderful financial advisors, family offices, and individual investors that have made running Five States such an enjoyable venture.

America’s Shale Oil and the Changing Geopolitical Landscape

Rarely do I read a book that is sufficiently interesting and provocative that I keep it on the shelf for further reference. One such book that has been so influential for me is The Clash of Civilizations and the Remaking of World Order, (1996) by Samuel P. Huntington, a political scientist at Harvard. His thesis was that people’s cultural and religious identities would be the primary source of conflict in the post-Cold War world.  Huntington argued that future wars would be fought not between countries, but between cultures, and that Islamic extremism would become the biggest threat to world peace.

For me the book provided a framework for understanding and interpreting relationships of world cultures as they were at the time, and suggested scenarios of future world politics, economies and events. It’s been interesting to consider events as they’ve occurred throughout the past two decades and consider how their likely causes aligned with Huntington’s forecasts.

I recently added another such book to my shelf: The Accidental Superpower, (2014) by Peter Zeihan. Its author, an international strategist, explores the thesis that the new U.S. abundance of shale oil is creating a new paradigm of worldwide geopolitical structure.

At the end of World War II, the U.S. stood alone in the world as the one great superpower. However, unlike victors in previous wars, the U.S. did not demand tribute from the defeated countries or move to permanently occupy and subjugate them. To the contrary, as set forth in the Bretton Woods Agreement, we established the principal of worldwide free trade, opened our markets to imports of foreign goods without tariffs or prescriptive restrictions, and set our navy to be the guarantors of worldwide deep-water shipping. In so doing, we protected shipping lanes to ensure the movement of the emerging supply of crude oil and refined products that our growing economy would need in the years ahead. The overall result has produced the longest period of generally peaceful relations among all neighboring countries, especially those of the European Union.

The U.S. and other countries have prospered during the past seven decades, and the U.S. has been assured a continuing supply of imported crude oil. However, the cost to the U.S. to be the world’s de facto policeman has been a drain on our economy and treasury. It was inevitable that we would need to reduce funding to our navy and its related facilities and services at some time.

Production of shale oil is providing the opportunity and rationale for the U.S. to trim its sails. The Domestic Energy Producers Alliance (“DEPA”) recently announced that the U.S. is now “officially energy independent”. The U.S. hit the “energy independence” milestone of zero net waterborne oil imports this year, as U.S. crude exports surged to a record 2 million barrels per day. The necessity of the U.S. to maintain its expensive navy may be largely obviated. As our navy is downsized, other countries may pick up the burden of the control of shipping lanes. Most of the increases will be by countries for their own border security and protection of export markets. But they will also become a threatening competitor to the U.S.

Because of many “accidental” factors, including such fortuitous items as relative isolation, friendly countries along our borders, and a broad network of navigable rivers for the transport of raw materials from the interior areas to port centers for manufacturing and/or export, the U.S. is more favorably situated to remain the world’s dominant superpower.

The book is really three: a survey of the resources and geography of the U.S. that have made possible our growth and achievements thus far; the evolution of shale oil and the dominating influence it has and will continue to have; and a discussion of the geography and population of various countries around the world – factors that will determine the probable winners and losers in the next several decades.

The Accidental Superpower is an interesting read for almost everyone, especially those of us intrigued by the geopolitics of the oil and natural gas industry. At a minimum, it is an affirming reflection of how fortunate we are to live in a country with such abundant resources and favorable geography.

 

Is the World Facing “Peak Demand” Rather Than “Peak Supply”?

For at least 100 years the world has been anticipating the “rapid exhaustion” of crude oil supplies. Will we continue to be as concerned in future years as we have in the past?

“Peak Oil”, the idea that global oil production would soon reach a maximum and then begin to decline, attracted a significant number of believers in the 1900s and early 2000s. The concept of Peak Oil developed from a theory put forth by American geoscientist M. King Hubbert in 1956. Based on overall reserve estimates and the pattern and history of field discoveries in the United States, Hubbert created a composite, mega-decline curve that predicted U.S. crude oil production would peak in the 1965-1970 time period, then continue to decline to ultimate depletion of the resource base.

And U.S. oil production did reach a peak, a little later than the original Hubbert curve predicted. But with the discovery of North Slope oil in Alaska in 1968, production began to increase again. It now appears that Hubbert’s approach predicts a profile for conventional oil production in a defined geographic area, under specified technological and oil pricing conditions.

In 2008, “unconventionals” happened. The combined technologies of horizontal drilling and hydraulic fracturing (“fracing”), when applied in shale and tight sand reservoirs, unlocked billions of barrels of oil and natural gas that had never been producible before.  Suddenly, hydrocarbon production in the U.S. began to increase. With rising crude production, the U.S. stopped soaking up the world’s excess oil supply.

Instead of cutting back crude production to balance the market, Saudi Arabia increased production to protect its market share. The result was a global glut of crude and liquids, along with a truly major price collapse.  Today you’re more likely to hear people talk about a possible worldwide peak in oil demand than a peak in oil production. One oilman quips, “The world keeps not running out of oil.”

But the principal arguments of Peak Oil haven’t changed much. Proponents of a production maximum point out that the worldwide discovery of giant and supergiant oilfields peaked in the 1960s and has been falling off sharply since then.  As more and more of those giant oilfields go into decline, they say, world crude production inevitably will decline as well.

Also, recent international exploration results haven’t been pretty. “Oil discoveries declined to 2.4 billion barrels in 2016, compared with an average of 9 billion barrels per year over the past 15 years,” the International Energy Agency (IEA) reported in its Annual Outlook.

“Meanwhile, the volume of conventional resources sanctioned for development last year fell to 4.7 billion barrels, 30 percent lower than the previous year, as the number of projects that received a final investment decision dropped to the lowest level since the 1940s,” according to the IEA.

One of the most consistent statistical trends through many years has been that worldwide oil demand growth has been about one million barrels per day each year. Even with a substantial increase in the development and consumption of renewables, the trend of increasing oil demand is likely to continue.  Most of the world’s developing countries have few alternatives but hydrocarbons to provide the transportation and electrical generation fuels to build their economies.

When people ask “How much oil is there?”, the answer must always be “At what price?” Exploration and development of natural resources are ultimately determined by anticipated future product prices, and even small changes in their direction can strongly influence development decisions.

What a Difference a Year Makes!

2017 opened with a much brighter outlook for the petroleum industry and the future for America’s energy security than did 2016.

At year-end 2015 the U.S. oil industry was in a funk. In the last seven months of 2015, oil prices declined 38 percent, from more than $60 per barrel in June to $37 by the end of December. During the year, the U.S. active rig count declined 61 percent, from 1,811 to 698, as contractors withdrew many of their rigs from service, stacked them in service yards, and released thousands of workers who had been required for drilling and completion operations.

Vocal public demonstrations against fracing were more frequent and strident. The practice of fracing was being charged for many alleged offences, including earthquakes, use of poisonous substances in frac fluids, and pollution of groundwater resources. Demonstrations were often actively initiated and/or supported by politicians, TV personalities, Hollywood starlets, press pundits and other public figures. Several communities and states passed laws restricting or banning fracing outright. Among those in the industry there was concern that without the ability to employ fracing, U.S. oil production would begin a rapid decline that would put it back on the downward slope that had existed in the U.S. from 1985 to 2006, before America’s Shale Revolution got underway.

Significantly, within the industry, an oppressive sense of angst was prevalent, as the EPA and other government agencies continued to expand and enforce policies of an anti-industry administration. Many wondered if a national “frac-ban” would be pursued which, if enacted, would likely end the Shale Revolution in the U.S., and with it, the opportunity to drill for and produce more than 95 percent of our nation’s proven petroleum reserves.

Looking back to 2005, there had been widespread concern that the U.S. was “running out of oil,” and the U.S. faced the unpleasant probability that it would need to continue increasing oil and natural gas imports required to fuel our vehicles and sustain our economy.

2017 opened to a very different scene. Oil prices had risen during 2016, closing the year at $53.72 per barrel. Most of the wells being drilled in the U.S. are in “resource plays”: oil shale or tight sandstone reservoirs that are expensive to drill and complete, and generally require oil prices above $50 per barrel to be economic. Some stacked rigs were now being put back into service.

Amazingly, during 2016 several of the largest oil fields ever discovered in the U.S. were announced. In August, Apache announced its discovery of the Alpine High field in Reeves County, Texas. The U.S. Geological Survey estimates that it could contain the equivalent of 20 billion barrels of oil, in an area largely written off as low-potential by previous workers.

In September, Armstrong Oil of Denver and the Spanish company Repsol announced that an often-overlooked rock formation on Alaska’s North Slope may hold a 120,000 barrels per day secret. Experts say it could be one of the largest oil discoveries in Alaska, holding upwards of three billion barrels of oil.

Then, in November, Caelus Energy, a privately owned and financed company in Dallas, announced its most recent discovery in Smith Bay on Alaska’s North Slope. Located about 60 miles southeast of Barrow and 160 miles west-northwest of Prudhoe Bay and the Trans-Alaska Pipeline, preliminary evaluation of the field indicates possible recovery of 2.4 billion barrels of oil. Caelus believes that the expanded area may contain upwards of 10 billion barrels of oil.

These new discoveries point to what experts say is a shifting reality for American energy producers … one in which deeply ingrained worries about a dwindling oil supply have become almost moot. “We will never run out of oil,” said Bernard Weinstein, associate director of the Maguire Energy Institute at Southern Methodist University.

Election Year Choices

On the threshold of the November elections, we are being assailed by both major presidential candidates with charges and counter-charges, uninformed rhetoric and strident babble. Neither candidate appears willing or able to discuss energy matters with reason, nor almost any other major issue.

The creativity and ingenuity of American geoscientists and engineers have led the world in unlocking the secrets of tapping underground vaults of energy. The technology of horizontal drilling combined with the 60-year-old technology of hydraulic fracturing (“fracking”) have been almost miraculous in creating riches that were unknown or untapped before. The individuals and companies that manage the drilling, extraction, and refining of the products have actually created real wealth, not just printed paper funny-money or redistributed currency that is already in circulation. In the process they have also created hundreds of thousands of high paying new jobs, putting millions of dollars in the pockets of workers and their families.

America’s abundant and available natural resources have provided us with energy that is effective and economical, giving us energy security and a competitive advantage in the global marketplace. They are riches that should be managed and maximized to the benefit of our nation. They can be shipped to other countries, bringing balance to our trade deficit and offering secure supplies to our friends. Locking them up will make us more dependent on foreign countries which are hostile toward our interests, thereby hurting our allies and our balance of payments.

There is just cause for celebration by all Americans! Abundant oil and natural gas supplies are also providing reliable supplies of gas-generated electricity for homes and businesses, lower gasoline prices at the pump with no worries about restricted quantities, and no fears that shortages will contribute inflationary pressures on the economy.

Yet almost throughout the entire “shale revolution” of the last decade, the oil and gas industry has been pulling its load uphill, against an administration that has done its best to hamper, cripple and ultimately decimate the creative and productive forces that provide bountiful benefits to its citizens. What it could not do through Congress, it has tried to do through executive mandates, the EPA, the Corp of Engineers, and a host of other governmental agencies. Its tactics have been to deny or delay permits, issue injunctions, and slow or stop industry activities in any way possible, occasionally acting against existing laws, regulations and policies.

The veto against construction of the Keystone Pipeline was one of the first of many administrative blows against the industry. Not only did it deny the operators drilling Bakken wells in the prolific Williston Basin of Montana and North Dakota a safe and economic method of moving their oil to market, it served to alienate our closest neighbor and trading partner, Canada, by slamming shut a means of getting its heavy oil to our refineries on the Gulf Coast.

The recent attempt of sabotage was to halt construction of the multi-billion dollar 1,172-mile Dakota Pipeline that runs from the North Dakota Bakken region to connecting pipelines in Illinois. It had previously been granted approval by all governmental agencies and was more than half completed when it was interrupted. Fortunately, a federal judge ultimately lifted the injunction and construction resumed. Meanwhile, the delay wasted millions of investors’ dollars.

The presidential election will have a big impact on the future direction of fracking regulations. At a March debate in Flint, Michigan, Secretary Hillary Clinton gleefully stated: “By the time we get through all of my conditions I do not think there will be many places in America where fracking will continue to take place.” In contrast, Donald Trump agrees with the courts and says fracking should be regulated by the states.

Realize that the attacks against hydraulic fracturing are not really about fracking. They are a covert way to halt domestic oil and natural gas development, as more than 95 percent of the wells drilled in America today use the technology. America’s new era of energy abundance is the direct result of horizontal drilling and hydraulic fracturing. Ban fracking, and you’ve essentially banned U.S. Energy Independence.

When Good Wells Go Bad

Like people, oil and natural gas wells have productive lives—they are born, decline over a period of time, then are put to rest. Also like people, the length of their lives can be affected by a variety of circumstances, both physical and economic. Ultimately, however, all wells reach their economic limit and can no longer be profitably maintained. They are then “plugged and abandoned.”

Of course, many wells drilled with high hopes turn out to be “dry holes.” In some of these, anticipated reservoir rocks are not present, are filled with salt water, or are too dense to allow passage of fluids through their pore spaces or fractures. Soon after the well reaches its targeted depth, such wells are filled with mud and cement and are sealed.

Wells that are deemed potentially productive are “completed,” a process in which protective steel pipe (known as “casing”) is cemented in place to prevent the hole from collapsing—safely protecting fresh water zones behind steel and cement and isolating gases and fluids contained in the various layers of rock. Perforating the pipe opposite the targeted formation allows oil to flow into the well bore where it can be brought to the surface and sold.
When wells are new, oil and gas entrapped in rocks nearest the wellbore are the first to enter, and production rates are high. As oil and gas are produced and reservoir pressures decline, fluids must move greater distances to reach the wellbore. Initial production rates may decline rapidly, sometimes as much as 90% in the first year, depending on the characteristics of the fluids and their host rocks.

Generally, after several years, production rates stabilize at lower values and future well performance becomes more predictable. All wells will continue to decline, but the rate of decline may be so gradual that the well may continue to yield low volumes for many years or even decades. Low rate wells, commonly known as “strippers” because they strip the remaining oil and gas from the ground, typically produce less than 15 barrels per day. Although they produce only about 10% of the total US oil output, stripper wells comprise 80% of the total number of US wells. At the end of 2015, there were around 380,000 domestic strippers, down by 19% from 2008. However, strippers still surpassed “non-strippers,” which totaled about 90,000 at the end of last year. These stripper wells are an important component of the economy as they employ thousands of oil field workers, support most of the well service sector, and each month provide income to several hundred thousand mineral and royalty owners.

Much of the imputed value of marginal production is in its “tail”—the long period of time after a well’s flush production has passed, its decline rate has leveled and, hopefully, the well has recovered its cost of drilling and operation. At such point, operational expenses are generally low and settled, and the operator can typically expect the well to continue to generate profits for many years. However, a sudden and significant decrease in oil prices or an increase in operating expenses will shorten the well’s economic life and truncate its projected future net revenue.

Five States and our investment partners are not totally immune from these problems. We own interests in many producing properties that are at or near their economic limit. We routinely review all our properties to “keep our garden weeded,” eliminating unprofitable properties that have little potential future value, but continuing to hold those that may prove more valuable in the years ahead.

As a well reaches the end of its economic life, operational expenses eventually overtake profits and the owner’s previous asset becomes a potential liability. The margin between profit and loss can be excruciatingly thin and is almost exclusively determined by daily oil prices.

Consider the situation in which the expenses of a well’s maintenance is equivalent to $40 per barrel (i.e. $40 oil is required for the well’s owner to “break even” each month). If the price increases to $45, the owner makes a profit of $5 per barrel; at $35 per barrel he loses $5. In other words, an owner of marginal properties must be willing to place a bet each day: continue operations with the expectation (or hope) that prices will eventually move higher, sell as soon as possible, or plug and abandon immediately.

Alas, such a decision is not a simple one. If he sells or plugs his wells, and prices suddenly turn upward, he has lost the opportunity to participate in what could be a bonanza. Because operating expenses are fairly independent of oil prices, small fluctuations in prices can result in significant leverage on profits. Every dollar above break-even drops directly to the bottom line. If prices suddenly plummet, as they did last year, an owner’s pain increases as he must “feed the kitty” for an indeterminate period.

Even though a well is producing at a loss, the owner likely realizes that it still represents a potential asset. Even after most reservoir pressure has been depleted and his production has declined to the economic limit, as much as 85% of the original oil in place (“OOIP”) still remains in the reservoir. Could a portion of the remainder be recovered by other means (e.g., water-flooding or the like)? Equipping his wells for such processes is time consuming and expensive, and may ultimately prove unsuccessful in the long run. If he is not well financed, where would he get the required investment capital?

The owner also knows that there may be other zones, perhaps deeper, that could be later drilled and exploited on his leased acreage. Is it worthwhile holding the leases by production until he can find companies who would finance the expenses of exploration and development, and provide additional value to him?

Even if he decides to plug and abandon his wells in order to eliminate expenses, or the state’s regulatory agencies require him to do so, he is not out of the woods. The expense of plugging and abandoning a well is likely to be greater than the value of recovered equipment (i.e., the “salvage value”). The owner may have to borrow funds from a bank or other source just to stanch his losses.

If he has already borrowed from a bank to drill new wells or fund operations, his problems are exacerbated. His loans may be collateralized by hedges placed during a time when oil prices were higher. Their value may be burning off monthly, making his collateral worth less than his loan, and leaving him unable to make principal and/or interest payments.

This is the situation of many individuals and companies in the oil business today: underwater, cash strapped, frustrated and scared. It is a common and unfortunate malady that seemingly occurs about every 10 years or so in our industry.

Good News – Bad News

The US Energy Information Agency (“EIA”) recently announced that production from wells drilled since the start of 2014 made up 48 percent of total US crude oil production in 2015. With the increased use of hydraulically fractured horizontal wells, new production as a percentage of total US production has more than doubled from 22%in 2007, according to the EIA. These are startling facts.

Crude oil production from hydraulically fractured wells now makes up the majority of oil produced in the United States. As of 2015, 51% of crude oil produced in the US came from wells targeting tight oil formations, most significantly the Eagle Ford and Permian Basin in Texas, and the Bakken and Three Forks formations of Montana and North Dakota.

Crude Oil Production

Consider what the combined technologies of hydraulically fracturing and horizontal drilling has meant to our country. Without them, if the average annual rate of US production in 2007 had continued to decline at the same rate it had during the past decade, US average daily production would now be at about 4.3 million barrels of oil per day (“bopd”), rather than 9.4 million as it was in 2015. We would now be importing 75%of our oil supply.

The benefits of increased oil production have been significant. Analysts and politicians agree that decreased reliance on foreign crude in the past few years has allowed the US to be more flexible in its foreign policy and given the US more global heft.

The US is now much less reliant on oil from the Mideast and elsewhere. Think of what that means, not just to our trade-account deficit, but to the reduced necessity of deploying many of our young men and women in the military to protect oil transportation routes.

Literally billions of dollars have poured into the hands of individuals, companies, and state and federal treasuries as a result of new production. Hundreds of thousands of land and mineral owners, many of whom live in areas that previously produced little or no oil or natural gas, now receive monthly royalty checks. That’s the good news.

US Oil Production and Imports

The bad news is that US crude oil production is falling in response to the collapse in oil prices that started in mid-2014. Output is now poised to drop below 9 million bopd—700,000 bopd off its April 2015 peak—and the rate of decline is accelerating, perhaps losing at least another 750,000 bopd by year end, a total drop of 16% in 18 months. That raises all-important questions of how low will US production go, and how much will oil prices need to rise to reverse those declines?

Rig Count by Drilling Direction

Of course, because the decline rate of production from horizontal wells is so high—as much as 90% from year to year—it takes a minimum of about 1,000 active drilling rigs to sustain the current rate of production. However, the total number of active rigs in the United States continues to fall. At the end of March, the number of oil-oriented rigs had fallen to 372, down 15 from the previous week, and down over 1,200 from the recent peak of October 2014. Further reductions are anticipated.

Oil Rigs in Operation

Producers fear they may never again experience the robust oil prices they enjoyed during the 2010-2015 period. The few oil-producing nations with spare production capacities, primarily Saudi Arabia, Iran, Iraq and, to a lesser degree, Russia, have demonstrated that, by maintaining high production levels, they can drive prices lower, and keep them there for extended periods. The effect has been to enable them to maintain their market share, and to make oil from US horizontal drillers non-competitive. For almost all the world’s oil exporters, today’s low prices are unsustainable over the longer term, but today they are successfully damping out aggressive drilling in the US.

At $40 per barrel, and with today’s drilling and completion costs, there are only a few spots in the major US shale plays where it makes economic sense to drill and produce more oil. For there to be a meaningful response from producers, prices must not only be higher than $55 per barrel, but producers must believe that it will stay at that level long enough to recover their investment and make a profit, and hopefully, continue to increase. Even though this is far below the $100 per barrel price of the shale heydays, many producers can make this work, especially if they have undrilled locations on leases held by currently producing wells. Progressively higher prices will bring on additional production. Estimated stable prices of $70 to $80 per barrel are required to put most of the US rig fleet back to work.

The bad news for U.S producers is that shale has so fundamentally changed the oil market that the word “recovery” is no longer relevant. That is because oil prices are now range bound, locked into a bracket which is capped at the high end, and with a floor at the low end. Above $55 per barrel, US production starts to increase, the oil market builds supply, and prices respond by going down. Based on recent experience, a price floor appears to be some number below $35 per barrel.

What Happened in 2015?

As the oil industry stumbles into 2016, everyone is asking the same questions:

  • Why did oil and natural gas prices fall so far and so fast in 2015?
  • Did anyone see the collapse coming? Did anyone forecast it?
  • Were OPEC or non-OPEC countries or groups to blame? Were individuals?
  • How long will current conditions last? Will prices recover?
  • Could prices go lower from here? Is there a floor?
  • What will happen to my oil and gas investments? Could I lose all my money?
  • What factors would have to change for prices to rise?
  • What’s the long-term outlook for the industry? Is this the time to be selling petroleum interests, standing pat or loading up?

Of course, no one has answers to all the questions, but in this article we will present the facts as we know them and share thoughts about where the future may take us from here.

The most likely explanation of the recent drop in prices was that oil traders suddenly recognized that the world is awash in oil and is likely to remain so for several years. Cited are full-to-overflowing storage tanks in Cushing, Oklahoma, and oil loaded tanker ships idling on oceans and docked in harbors throughout the world, just waiting to offload millions of barrels to refineries and power plants. Price-bears note that oilfields in Iraq were back to producing almost 4.5 million (MM) barrels of oil per day (“bopd”) in November of 2015, and that Iran has resumed production and announced intentions to increase to 3MM bopd in the near future when sanctions are lifted. On a statistical basis, global inventories built by 2.0 MM bopd in the second and third quarters of 2015. These are the largest inventory builds since the fourth quarter of 2008. The EIA forecast that global inventory builds started to decline in the fourth quarter of 2015 to 1.4 MM bopd and will average only 0.6 MM bopd in 2016.

The possibility of a continuing worldwide oil glut is a concern to producers. In previous times, when oil markets became sated, OPEC, led by oil behemoth Saudi Arabia, acted as the world’s swing producer, cutting back production in order to maintain price stability. This time Saudi is showing no indications of slowing production anytime soon, and in fact is working to produce more. They are attempting to regain their market share at the expense of high cost producers, including US shale drillers. US production appears to have peaked in May of 2015 at 9.4 MM bopd.

Everyone is waiting for the other guy to flinch on production. Until someone does, the price of oil is likely to remain low. Although the Saudi production cost is less than $10 per barrel, social welfare programs take the all-in cost to $100 per barrel. The Saudis are beginning to utilize their cash reserves and have even discussed monetizing a part of Saudi Aramco through a public offering.

A second factor influencing prices is investor perception of future supply and demand. Because there are limited substitutes for oil, a relatively small perceived or actual shortage/surplus in the worldwide balance of supply and demand can cause wide price swings. A relatively small quantity of surplus barrels in the system is interpreted by the public as unlimited supply, and prices fall. A few barrels temporarily unavailable for immediate needs can create panic. Markets react as if the world will soon run out of oil, and prices soar. The tail wags the dog: the price of a few barrels can establish the price of millions. The pendulum can and does swing rapidly and widely in both directions.

Little more than a year ago, US producers were on a roll. Wells were being proposed and drilled in record time, production was increasing, and the US was reducing its unfavorable balance of payments gap. In November 2014, oil closed at $91.16. As US storage capacity disappeared and OPEC stood firm on production quotas, prices fell: to $53.27 in December 2014, and further to $34.66 in December 2015, a collapse of 62% in only 13 months.

Oil-bears recognize that US oil producers, through horizontal drilling and multi-stage hydraulic fracturing, have unlocked the secrets of obtaining oil and natural gas from the world’s bountiful shale reservoirs. The bears believe now that the genie is out of the bottle, the world’s oil producers will acquire and utilize them, and oil will no longer be a scarce commodity.

A third factor that may lead to disastrous consequences for many companies is the extensive use of borrowed capital. The disadvantage of America’s high-tech shale-play is its high cost. Competition for prospective oil and gas leases has been frenetic. Drilling and completion expenses are high. In their rush to exploit leases before they expire and to “prove up” as much of their potential reserves as possible, aggressive companies have been drilling as fast as they can, typically borrowing as much as banks and private investors would allow.

Collateral to secure the loans has often been producing assets, hedged by futures contracts purchased to assure deliveries at specified prices. Over time, higher price contracts have been expiring and new contracts are at much lower prices. The result is that many bank loans are now in non-performance status and are likely to be called for repayment in 2016. By some estimates, as many as one-half of existing E&P companies, especially the newer, highly leveraged shale drillers, will be out of business by the end of the year.

Prices may be further weakened by increased usage of renewable energy. But despite the growth over the last few years, wind and solar account for only 2 ½% of US energy supply. Further production and efficiency increases are expected, but most authorities do not believe renewables can or will substantially replace oil and natural gas based transportation fuels within the next decade or so.

Facts for the oil-bulls’ case can be equally persuasive as for the bears’. Oil and natural gas are commodities, and at the fundamental core, prices are ultimately determined by supply and demand. Energy is essential to the economies and well-being of all countries. The more energy one has, or can get and use, the stronger, healthier and more viable is its economy. The US, with only 6% of the world’s population, uses almost 22% of the world’s annual energy production, but is able to generate 22% of world’s nominal economic output. We are an immensely successful nation specifically because we have great natural resources, and have learned to use them effectively.

The world requires about 94 MM bopd. Annual demand is increasing about 1.1%, or 1 MM bopd. Worldwide spare capacity is now only about 2 MM bopd above daily production, down from about 8 MM bopd only a decade ago. The International Energy Agency (IEA) projects that by 2020 the world will need another 6 million bopd, outstripping the spare capacity of OPEC. In other words, demand has been increasing while spare capacity has been decreasing. The decreased margin of safety increases price volatility.

With world population continuing to increase, and with the citizenry of developing countries demanding more goods, services, and access to better transportation, the question is whether enough oil and natural gas will continue to be available to meet future demand. Exxon estimates that global population will grow from 7 billion in 2010 to 9 billion by 2040. Even if the per person consumption of energy stayed the same, energy demand would increase by 28%.

US production of shale oil is currently 4 MM bopd. Unlike production from conventional sandstones and limestone reservoirs, which typically have longer lives and slower decline rates, production from shale reservoirs have steep decline rates (up to 90% in the first year) and shorter lives. The result is that production from shale oil fields must be increased or maintained by continued, active drilling programs. If wells are not being drilled, production declines rapidly.

When oil prices began their decline in November 2014, drillers began taking rigs out of service and laying off employees. From a high of 1,931 working rigs in November of 2014, the number has plummeted to fewer than 700. US shale oil production has already declined by more than 500,000 bopd. Projections are that it will have declined by 1 MM bopd by mid-2016. In other words, without drilling as many or more wells than were drilled in 2014, US production will continue to decline rapidly.

Of course, the real wild card in the supply/demand picture is the possibility of turbulent disruptions in any of the world’s major oil producing areas, particularly in the Middle East or the Former Soviet Union. The loss of sustained production in one or another of those hot spots would immediately and dramatically drive prices skyward. The effects of such disruptions are to no country’s best interest, but it is not out of the realm of speculation.

For the present, we at Five States believe that opportunities to acquire quality producing properties may soon be among the best in our careers. A recent article in the Dallas Morning News cited a prediction that half the oil companies now in business would declare bankruptcy and/or go out of business in 2016. Many of their assets and producing properties will be sold at prices much below their value at year-end 2014.

Riding the Cycles

No one needs to inform west Texas citizens that the oil and natural gas industry is currently in a slump. All one has to do is drive from Midland to Odessa and count the number of drilling rigs standing idle in storage yards, or pick up a copy of Midland’s The Daily Observer to read about oilfield layoffs, diminished company profits, and numerous mergers and acquisitions.

Anyone who has lived in the Permian Basin for more than a decade has experienced the effects of major downturns. Old-timers who can remember the days in the 1950s and 1960s when $3 per barrel oil and 18¢ per MCF natural gas were the norm have lived through five major price collapses. Most of us who have been around the business for any length of time have learned to accept periodic industry retrenchments as normal, and have developed something of a bunker mentality about dealing with them.

Cyclical downturns can actually be the “Best of Times” or the “Worst of Times” for oilmen and their investors. They are created when oil and natural gas prices decline rapidly, usually unexpectedly, and remain low for an extended period. The first major decline since $3 oil started its upward run in 1973 occurred in 1985, when the benchmark price of a barrel of West Texas Intermediate crude oil dropped 62.4%, from $30.81 to $11.57. The resulting jolt was sufficient to create havoc in the oil fields, bankrupt companies, and ultimately contribute to toppling major banks in Dallas, Houston, Oklahoma City, Denver, Chicago and elsewhere that carried large positions of oil and gas debt in their loan portfolios.

Five States was chartered in 1985 in the midst of the wrenching price decline of that year. As prices withered, banks initially began calling in oil loans of borrowers who were in default on debt covenants. Within months, as their debt to asset ratios continued to worsen, the banks began calling in loans from their “good” customers who were still current with scheduled repayments and still compliant on their covenants. Some of these borrowers, unable to raise funds from alternative sources, lost their properties and sometimes their companies in the melee.

Billions of dollars of oil and gas equipment, producing properties, royalties and minerals, oil field service companies and operating companies were thrown on the market, available to anyone who had enough money and courage to bid on them. For some individuals, it was the end of the line. For others it was the beginning.

In such times, the difference between losing a company or starting one is often the availability of or access to capital. Although Five States had only modest assets and a small bank account at the time, we had the experience to recognize that good value properties were on the bargain table. We also had little overhead and no debt. The only missing ingredient was cash. We began knocking on doors as far from the oil patch as possible, hoping to find investors who would listen to our story. A few did, most noteably fee-only financial advisors.  Five States’ upward cycle had begun.

Although oil prices began to recover the following year, it took more than a decade for confidence in the industry to be fully restored, for new banks and capital sources to become well established, the glut of producing properties to finally be settled in new hands.

For most young companies, and those aspiring to grow rapidly through acquisitions and the drill bit, institutional capital and bank debt are essential elements in their development. Serious problems can and do arise when, in the flurry of their activity and achievement, a drop in commodity prices slashes revenue, debt becomes unmanageable, and the companies fail.

In recent years, the commodities futures markets have come to be utilized much more widely and effectively to lock in forward prices, protect collateral and reduce risks of commodity losses. Even so, companies who carry high debt loads, especially over longer periods, always face the possibility of catastrophic losses.

Five States has always been a conservative player. Our focus on investing in long-life legacy oil properties that generate strong operating margins provides us a stable financial foundation.  With excellent financial partners willing to provide capital when needed, a knowledgeable and experienced staff, relatively low debt ratios, an envious track record, and a reputation for competence and integrity, we believe that we are again moving into a new cycle of attractive acquisitions, growth and success.

30-Year Anniversary Events

Five States is celebrating our 30th year in business! We gratefully acknowledge the confidence and support of the many financial advisors, investors, business associates, employees, and friends who have been a part of our success and growth through the years.

Many of the company’s current activities are “business as usual”: reviewing investment submittals, analyzing and evaluating prospective projects, making lease inspections, and visiting construction and development sites. This year we are making special efforts to initiate new industry contacts, strengthen existing relationships with current investors and advisors, increase our visibility by sponsoring more industry events, and provide opportunities for staff members to be featured speakers at professional and trade association meetings.

To that end, Five States recently hosted a three-day investor field trip to Midland. Fourteen individuals attended, including five from Five States and nine guests representing seven investment groups from around the country.

A brief reception at the Doubletree Hilton kicked off the first evening, followed by dinner at the nearby Wall Street Café. On the morning of the second day, an orientation at the Permian Basin Petroleum Museum introduced the group to the Permian Basin’s geology and oil industry history. Everyone had the opportunity for up-close inspections of a drilling rig, pumping units, and other types of production equipment.

Following lunch, the group visited facilities of the Advantage Pipeline System, an 87-mile pipeline from Pecos to Crane, Texas, in which Five States’ Fund 1 has a substantial investment. The facility includes oil truck off-loading facilities, storage tanks, and pipeline pump stations. The Advantage Pipeline System currently gathers and transports more than 70,000 barrels of oil per day, delivering them into the Longhorn System that moves oil from West Texas to refineries on the Texas Gulf coast.

That evening, Five States hosted a celebratory anniversary reception at the Petroleum Club of Midland for our guests, as well as many of Midland’s independent oil men and women. Investors had a great opportunity to meet with and ask questions of knowledgeable and experienced professionals.

After breakfast on the third day, we visited a rail terminal which handles tank cars transporting oil produced nearby, as well as open-top rail cars that bring in frac sand used in wells to hydraulically fracture dense, oil-bearing rock formations. Guests expressed appreciation for the visit and said that they had learned much about field operations during their brief time in Midland.

Five States will continue to work throughout this year to expand our network of business associates and to uncover opportunities that can provide lucrative results to our investors in the months and years ahead.

The Oil Glut

Global oil prices are now near five-year lows. US producers are feeling the pain; they are not alone. Low oil and natural gas prices are causing companies and governments throughout the world to reexamine their budgets, rethink their priorities and, in some cases, make major policy decisions based on the possibility that significantly higher prices may be a long time coming, if ever.

In July of last year, oil was trading above $100 per barrel. Since January of 2015, the average price has been less than $50. The new technology of horizontal drilling combined with multiple stage hydraulic fracturing has unlocked literally billions of barrels of oil from tight reservoir rocks. Since 2005, US oil production has been increasing at an astonishing rate. The US is now the second largest producer in the world, close behind Saudi Arabia. “This is a historic turning point,” historian Daniel Yergin said. “The defining force now in world oil is the growth of US production.”

The result has been the development of a worldwide oil glut that has hammered commodity prices. Here in the US, lower prices have idled half the fleet of drilling rigs, necessitated the layoffs of thousands of workers, and are wreaking havoc among the independent oil and gas operators who depend on operating cash flow to fund their businesses. Around the world, the glut is creating some significant geo-political ripples.

As was recently pointed out in a talk by Ken Hersh, chairman of Natural Gas Partners, the world is suddenly shifting from one of energy scarcity to one of energy abundance. “It’s a world in which the economics of scarcity, whose rules are determined by producers, are being replaced by those of consumers, who are benefitting from lower prices,” Hersh said.

For American motorists, the price-drop is providing a windfall. The average price of a gallon of gas is more than a dollar lower than it was a year ago, a huge savings to consumers who are putting much of it straight back into the economy, buying clothes, electronics, restaurant meals and other items they might not otherwise splurge on.

Worldwide, lower prices could imperil the economies of petro-states such as Venezuela, Iran and Russia. Analysts believe OPEC, whose 12 members account for around one-third of the world’s oil supply, is trying to drive some US shale producers out of business. Saudi Arabia, which effectively leads the cartel, has so much wealth it can handle significant losses, but for countries whose economies rely heavily on high oil prices, the outlook is much bleaker.

The West now has more leverage over rogue petro-states. Until the US made the accommodative agreement with Iran over Iran’s nuclear program, Iran could no longer rely on high oil prices to soften the impact of economic sanctions. For a time, the US had an opportunity to make a favorable deal. Similarly, Russia now has more reason to pull back on its aggression toward its neighbors, and even to make sales of natural gas to China, which it might not have previously considered. Whether Mr. Putin ultimately accedes to the pressure to lessen his belligerency toward Ukraine is still to be determined.

Venezuela is in even worse financial straits. Inflation is a staggering 60%, and currency controls have generated scarcity of basic needs. In the past, President Nicolas Maduro, and his predecessor, Hugo Chavez, hid the perilous state of Venezuela’s finances behind populist policies funded by vast oil revenues. Now political upheaval is a real possibility.

The US benefits in other ways by its new largess. Oil imports are, and have historically been, the largest component of our foreign trade deficit. Every barrel produced domestically replaces one otherwise imported. Since 2005, when production of shale oil began coming on the market in significant volumes, the US has reduced its dependence on oil imports from 72% to 16%, an amazing accomplishment.

The US has spent billions of dollars in military support to protect oil transport ships in hazardous areas, and to provide military equipment and personnel to those countries considered critical to a continued secure supply. With less dependence on imports, the need for a continued high level of support might be reduced.

Further, with increasing supplies, the US dollar becomes stronger, and our government’s hand is strengthened in negotiations with foreign governments. We have the opportunity to regain our reputation as a stable and reliable partner to our friends and allies, and to be less required to deal with unfriendly regimes merely because we need to purchase their oil.

2015 Energy Issues Outlook

Each year, JP Morgan writes a “deep dive” piece on energy. The report is a well-researched analysis that covers several specific topics. We find the report to be informative and useful as a basis for understanding current issues and forming opinions pertinent to our industry. This year’s topics include the history of energy development and the eventual transition to renewable energy, the impact of US shale oil on US energy independence and the latest trends in nuclear, wind, solar and energy/electricity storage. In this issue of The Producer, I offer a much condensed summary of the topics discussed in the JP Morgan report.

While the world has become twice as energy efficient over the last 50 years, global consumption of primary energy is three times higher than in 1965. The finite nature of fossil fuels, the increasing cost of extracting them and their environmental impacts are prompting the US and other countries to plan for greater reliance on renewable energy. What is on the horizon, and what factors will determine our energy future?

1. US energy independence in light of increasing domestic oil and gas production.

Rising US shale oil production makes US energy independence feasible by 2025. It has brought down the marginal cost of oil, and coincided with slowing oil demand for both cyclical and structural reasons.

Since 2006, the US has reduced its net oil imports from 60% of our supply to less than 30%, providing enormous savings to our nation’s economy and citizens. However, the ability of US producers to continue to ramp up production at the pace of the last decade will depend on several factors: robust industrial growth in the US and other countries, oil prices that provide adequate profit margins to producers, relaxing the ban on oil exports, and increasing light-oil refining capacity.

2. The rising cost of nuclear power.

Once thought of as a long-term bridge between fossil fuels and renewable energy, rapidly rising costs have slowed capacity additions outside of Asia. An analysis from France shows rapidly increasing capital and operational costs over the last decade. A prior assessment using data from the year 2000 estimated overall costs at $35 per megawatt-hour (MWh). The French audit report set out in 2012 to reassess historical costs of the fleet. The updated audit costs per MWh are 2.5x the original number.

In 1945, physicists predicted that nuclear breeders would be man’s ultimate energy source. A decade later, the chairman of the US Atomic Energy Commission predicted that energy produced by atomic reactors would be “too cheap to meter.” Today the picture is clear: the days of nuclear energy being a cheap way to add base load power are likely a thing of the past.

3. Wind power and the issue of questionable continued government subsidies.

US wind capacity was growing rapidly, and was ahead of the DOE’s “20% by 2030” plan until new capacity additions collapsed in 2013. A variety of factors make the next decade more uncertain for wind than the prior one.

Every year, Lawrence Berkeley National Laboratory publishes an annual wind study on the US, which gets 4% of its electricity from wind. There are factors which favor increased deployment of wind turbines: declining upfront capital costs, declining instances of involuntary wind power curtailment, and increasing transmission line deployment. However, those issues obscure the “elephant in the room”: continued reliance on subsidies to maintain capacity growth. Subsidies have been in place almost continuously since 1994. Whenever subsidy extension was unclear, capacity additions fell in the following year by 79%-90%. Without subsidies, it would probably be difficult to mobilize private sector capital for wind projects without cash grants, production tax credits, or investment tax credits.

4. Solar power in the US: An early look.

Analysts at Lawrence Berkeley National Laboratory now have enough critical mass to look at solar costs, capacity factors and growth potential. While costs have declined sharply, photovoltaic solar energy is starting from a very low base and relies heavily on continued subsidies and the continuing decline in module process costs.

Although sunlight has the highest theoretical potential of the earth’s renewable energy sources, its real-world limitations and costs have made its adoption slower than wind. The US gets just 0.2% of its energy from utility-scale and large commercial solar installations. Capacity forecasts from the Energy Information Administration and the Solar Energy Industries Association imply that solar’s contribution will rise only to 0.6%-0.9% of US electricity generation by 2016, which would still leave solar behind biomass.

5. Electricity storage.

Renewable energy intermittency can be mitigated by increased interconnectedness of electricity grids, or through advances in energy storage. The latest update from Sandia National Laboratories indicates that the going has been slow thus far, but there has been some progress in the lab.

Most electricity is used when generated and not stored. Storage facilities are equal to just 2% of installed global generating capacity, and most can only store minutes to a few hours of supply. The most common approach is pumped storage: pump water uphill into a naturally-occurring or man-made reservoir at night when electricity prices and demand are lower, and discharge the water downhill to spin a turbine during the day when prices and demand are higher. According to the Electric Power Research Institute, pumped storage accounts for 99% of all electricity stored around the world.

Other methods of energy storage include compressed air, thermal storage, batteries, hydrogen storage, and flywheels. All may have potential use in specific instances, but large scale storage is still more of a concept than reality.

Fracking Good

America’s shale is changing the dynamics of world energy. The reemergence of the United States as a global energy superpower is addressing many of the major problems in the United States and is having profound strategic and geo-political effects throughout the world. In November 2012, the U.S. replaced Saudi Arabia as the world’s largest producer of crude oil. The U.S. had already overtaken Russia as the leading producer of natural gas, and the International Energy Agency predicts that the U.S. could become the world’s largest natural gas producer by 2017.

In his 2012 State of the Union address, President Obama claimed credit for presiding over the largest reduction in oil imports in modern history and for achieving the lowest level of dependence on oil imports in years. He attributed that remarkable performance partly to increased oil production from tight sands in the Dakotas, but primarily to the massive increase in gas production that has resulted from fracking.

The Energy Information Administration (“EIA”) predicts that the U.S. will have enough gas to satisfy domestic demand for a century and that the U.S. will soon have a surplus sufficient to begin exporting gas to Asia. As a result of fracking, natural gas costs less than one-third of the energy-equivalent price of oil in the U.S. The developing use of natural gas in fleet passenger automobiles and in medium to heavy long-haul trucks has the potential to reduce gasoline sales, fuel costs and prices of manufactured goods delivered to stores.

Natural gas currently generates 30% percent of the electricity in the U.S. (coal 37%, nuclear 19%, all others 14%). Low relative prices of source fuels in the U.S. are improving U.S. economic conditions and are increasing manufacturing activity by significantly reducing the cost of energy.

The fortuitous increase of U.S. oil and natural gas production is resulting from the synergistic application of two petroleum technologies, one old and one new.  Hydraulic fracturing, developed in the 1940s, has been safely employed in more than a million U.S. wells. More recently, the industry has commercialized the ability to drill wells horizontally. Such wells are drilled vertically to a depth of one to two miles then turned to drill horizontally within the oil or natural gas bearing strata. Steel pipe is cemented through the entire length of the wellbore and holes are opened in the pipe. Hydraulic fracturing of the rocks in the horizontal portion of the well releases the oil and natural gas and allows them to be recovered at the surface. Without the combined use of both technologies, little of the new oil or gas production in the U.S. would be possible.

Since 2004, various senior federal regulatory officials from both the Bush and Obama administrations (including the EPA and Department of Energy), state regulatory agencies, and university researchers have repeatedly noted the lack of evidence connecting groundwater contamination with hydraulic fracturing. Peer reviewed research studies in 2012 and 2013 found groundwater contamination from vertical migration of fracturing fluids “not physically plausible” and “unsupported by any empirical data.” In August of 2013, newly appointed US Secretary of Energy, Ernest Moniz, said “To my knowledge, I still have not seen any evidence of fracking per se contaminating groundwater” (emphasis added).

Fracking is improving the U.S. environment by replacing some coal with natural gas. Even though the economy has expanded by more than half, U.S. greenhouse gas emissions are lower today than they were 20 years ago. This is because of the greater use of natural gas for power generation and industrial boilers.  Although the U.S. was not a signer of the Kyoto Protocol, the U.S. emissions are already below the limits that would have been imposed by the protocol as a result of the switch to natural gas released by fracking. The U.S. is the only industrialized country in the world to meet this level of Kyoto Protocol compliance.

Fracking will improve the global economy. Natural gas is far more expensive in Europe and Asia than it is in North America. Fracking in other countries has great potential to reduce the price of gas in those areas. The EIA has identified 48 shale gas formations in 32 countries that have the potential to yield new gas supplies comparable to those that have nearly doubled U.S. gas reserves in the last decade. Horizontal drilling and hydraulic fracturing in basins outside the U.S. can, at minimum, triple global gas supplies.

Fracking will improve the global environment. As fracking increases the global supply of natural gas and reduces the price of natural gas in Europe and Asia, the same kinds of dramatic beneficial effects on the global environment will occur that are already beginning to impact the U.S. environment. The International Energy Agency (“IEA”) predicts that by 2030 gas will displace coal as the dominant source of energy in the world. China is poised to become a particularly large beneficiary of the gas boom. IEA has identified several promising basins in China. IEA also predicts that by 2030 China will consume more gas than the entire E.U. Since China is the world’s largest source of greenhouse gas emissions and by far the largest source of emission increases, any replacement of coal with inexpensive natural gas has the potential to greatly reduce China’s problems with air quality.

Fracking should also improve geopolitical conditions. The process is reducing–and may ultimately eliminate–U.S. dependence on oil and gas from insecure foreign sources such as the Middle East. Fracking can reduce Russia’s leverage over Europe via new gas supplies, Iran’s leverage over India via India’s reliance on energy supplies from Iran, and the risk that Russian President Vladimir Putin will be successful in his efforts to create a natural gas version of the OPEC cartel.

In the U.S., continued development of our vast natural oil and gas resources will be accomplished only if regulators and producers are able to work together to satisfy citizens and regulatory agencies that horizontal drilling and hydraulic fracturing of shale formations can be accomplished with tolerably low environmental costs. As active participants in the oil and natural gas industry, we see this as a tremendous opportunity to create jobs, wealth and energy security for our country. Continued development will reverse the decline in U.S. industrial competitiveness, the standard of living and the undesirable geopolitical position that reliance on imported energy is creating for us.