Current Events,  Mile High View

The Impact of Fracking

The stock market selloff Thanksgiving week 2018 was the worst Thanksgiving week since the 1930s, during Franklin D. Roosevelt’s administration. Why this sudden drop in a year of highs? And what impact will we see? In my opinion, the selloff stems from changes in the largest industry in the world. And few people recognize it.

The Bush-era tax cuts, the largest ever passed, saved the average family $315 a year. The changes that are taking place now will save the average family $1,750 a year and will probably increase. Oil prices dropped from $76 a barrel to $51, and I expect oil will gradually drop even further.

The energy industry produces approximately $7 trillion annually. By comparison, the entirety of the media industry is about $1 trillion. The energy industry is going through a disruption that is more like a seismic revolution. While renewable “green” energy is a large part of the change, the biggest disruption is fracking.

Most people have heard of fracking; few know what it is and the industrial change it will bring. The United States is the earliest and biggest beneficiary and may maintain that status for possibly decade or two more. There are unique characteristics that make America the leader in this relatively new industry.

Conventional oil extraction consists of drilling a horizontal shaft into a pool of oil. The drilling is essentially straight down hundreds of feet, or possibly miles, below the surface of the earth and into a lake of oil, and then pulling, or sometimes forcing, the liquid to the surface to recover.

Fracking turns that process on its ear.

Most petroleum derives from long-dead plankton and algae that sank to the bottom of a body of water, mixed with the mud and bacteria,and became a substance called kerogen. Eventually forced deep beneath the crust of the earth, the kerogen was put under high pressure and mixed into the rock strata as petroleum. Some of those small bits of petroleum, under geological pressure, begin to form the pools that we drill into for traditional oil drilling.

However, the large majority of those bits of petroleum,maybe 90% or more, never migrate. They rest in tiny pockets as small as a micron (less than the size of a human hair). Fracking is the process of accessing those small bits of petroleum. Most of those dots of petroleum are in shale rock. Shale rock is not porous, and to drill into it, the frackers drill vertically rather than horizontally. The Absent Superpower pictures this like drilling into ravioli (traditional oil drilling) versus lasagna (between the layers).[1]

Just drilling is not enough. The shale does not easily give up its tiny bits of petroleum. The fracking process involves pumping millions of gallons of pressurized water and sand into the wells to force out the petroleum and fill the tiny void holes with the sand. Because the pockets are essentially untouched, the oil produced is the least contaminated equivalent to what is called “sweet oil,” or oil lighter than most produced by OPEC.

Although there is some concern over the environmental effects of fracking, we are constantly developing new technology and techniques to resolve these concerns.

The United States has become the world leader in fracking for three reasons. First, the US has a legal structure that permits fracking.Many of the countries in Europe have drilling restrictions that prevent it.Second, the United States is the financial leader of the world. Fracking requires large amounts of capital equipment and the US has private companies that can afford to put in the necessary funding. Finally, the US has the transportation that can move the product.

Natural gas is a gas. To cook the Thanksgiving turkey would require a walk-in closet size volume of natural gas in its natural form. To liquefy natural gas huge amounts of pressure have to be applied. That pressure needs to continue all along the transport route, whether pipeline, truck or container ship.

Because of fracking, the United States has moved from being a nation that was dependent on oil imports to an oil independent nation and, in fact, an oil export country.

So what does this have to do with what we have seen in the market over Thanksgiving? The price of oil dropped from $76 to $51 a barrel.Part of the drop was due to Saudi Arabia increasing production as President Trump stated. But that was a minor reason. Fracking is bringing oil prices down.

10 years ago, in the early stages of fracking, the cost of fracked oil was in the $70 to $90 range. When oil prices were slammed down in 2015, frackers began to find ways of making fracking less costly. Today frackers make money on $50 oil. In my opinion, we will see fracked oil continue to become less expensive to produce. That will keep oil prices low.

In the larger picture of energy production solar is growing at 30% per year but is still only 7% of total energy produced. Solar is limited to daytime production. Nighttime, when the sun isn’t out, requires electricity from traditional sources. Natural gas today already supplies 40% of US electrical production. Natural gas is cleaner and competes with coal. Over 500 coal plants have been shuttered in the United States and that trend figures to continue with the advent of renewables and natural gas.

Fracking is spreading to the rest of the world. Countries such as Australia, Bulgaria, Canada, China, Denmark, France, Germany, and others are all beginning to frack natural gas and light oils. While 70% of the coal plants are in Asia, and coal plants are still being built there, I predict that Asian countries will within the next five years also be fracking for lighter fuels.

My focus in investing, writing these letters, and hosting the KLFE radio program is to “stay ahead of the curve” – to be proactive, not reactive. I believe the landscape in energy is changing, and that means traditional energy investing is going to be the wrong place to be.

[1]Zeihan, Peter. The Absent Superpower: The Shale Revolution and a World Without America. Zeihan on Geopolitics, 2017.