True Cost of Fracking

The U.S. energy outlook would be much different without hydraulic fracturing.  ‘Fracking’ as it is called today has been around for over a century.  In the late 1800s it was called ‘shooting the well’ when an explosive was lowered into an oil well and detonated.  Surrounding rock was shattered, allowing water to be pumped in and then extracted along with the bits of oil that had been held in the rock. 

Fracking has changed significantly since those early days, giving the oil and gas industry reason to embrace this wellhead procedure with enthusiasm.  One key change has been the replacement of explosives for more benign materials.  Instead, mixtures of sand and chemicals suspended in water are pumped under high pressure into oil and gas wells.    Of course, there is a nickname for that too  -  ‘slickwater.’  Additionally, oil and gas developers figured out how to drill horizontally.  First, the well is drilled down vertically and then out horizontally for as far as two miles. 

Deployment of hydraulic fracturing in tandem with horizontal drilling has made possible the extraction of oil from shale rock formations that had previously been passed over as not economic.  Several regions of the U.S. that were once sleepy backwaters have become icons of the oil and gas industry:  Bakken in North Dakota, Permian in Texas and Eagle Ford also in Texas.

U.S. oil and gas companies have been delighted to adopt hydraulic fracturing as a means to compete head on with Middle Eastern and Russian producers.  The Wall Street Journal reported that U.S. oil output reached an all-time high of 11.5 million barrels per day in 2018.  More recently in December 2019, according to the U.S. Energy Information Administration, U.S. oil product has backed off to 9.1 million barrels per day.

Coming to the market with domestic production has delivered a windfall to U.S. oil and gas companies.  Unfortunately, business models and practices remain well entrenched to the detriment of consumer welfare. 

Consider first the cost of hydraulic fracturing.  According to a survey completed by Reuters in early 2019, oil and gas producers using fracturing equipment and methods can break even if the global oil price is at least $50 per barrel.  Ten years ago when the going price for a barrel of crude oil was well over $100, shale oil producers were raking in exceptional profits.  They had little incentive to adopt any technology that might increase the cost of hydraulic fracturing for the sake of energy efficiency or environmental benefit.  U.S. oil and gas companies have been too hungry for profit.

One need only look at the experience of Energy Recovery (ERII:  Nasdaq) and its Vorteq hydraulic fracturing pump.   The Company made its bones with a pressure exchange technology that reduces energy requirements in reverse osmosis desalination plants.  Energy Recovery put the same technology to work in the pumps used for sending ‘slickwater’ into shale oil wells.  The Vorteq extends pump life and nearly eliminates costly pump failure episodes.  A marketing and distribution agreement with oil and gas industry supplier Schlumberger Ltd. (SLB:  NYSE) nearly guaranteed market penetration. 

What has been the pace of adoption of Energy Recovery’s Vorteq by the oil and gas industry?  Well, dismal.  By the time the company got all the bugs worked out of its pump machinery, the global price of oil had plummeted to the current level in the higher $50s.  Even the promise of overall savings on pump operating costs has not been a sufficient incentive for either pumping companies or their production customers in the shale oil patch. 

A slightly better but similar reception has held back hydraulic fracturing technology developer Evolution Well Services.  Its electric fracking system, or e-frac as it is known in the oil patch, replaces conventional diesel powered fracturing engines and transmissions with an electric motor and electronic controls.  Gas turbines are the electricity source for Evolution’s patent-protected e-frac equipment.  Not entirely free of greenhouse gas emissions, gas turbines still compare quite favorably to diesel engines in terms of efficiency and carbon emissions.

Evolution Well Service claims its e-frac system could cut costs per oil well by $200,000 despite the significantly higher capital costs compared to wells run by conventional diesel power pumps.  Crucial to the cost-benefit pitch by Evolution and other e-frac equipment providers is the use of flare gas at the well site to power the gas turbines.  Even if flare gas is not available there are other savings sources, such as 50% reduced crew requirement and the elimination of hazards associated with ‘hot fueling’ of diesel engines. 

Evolution recently worked on wells for shale producer EOG Resources in the Eagle Ford oil patch.  Altogether Evolution operates six e-frac fleets.  The pace of adoption has been slow for the company.  Indeed, only about 3% of shale oil hydraulic facturing fleets have adopted e-frac technology. 

The experience of Energy Recovery and Evolution Well Services is typical of the oil industry in general.  As long as the equipment in the field is pumping out oil at a marginal cost at or below the price they will get when they haul it to market, oil and gas production decision makers are reluctant to make capital investments. 

Here is the point at which our business practices let our capital markets fail consumers and society.  A properly functioning capital market would cause business leaders to adopt the most effective and efficient production equipment and methods.  Yet the oil and gas industry does not have to come to terms with the true cost of production, because they are able to ‘externalize’ to other parties the cost of inefficient resource use, inadequate safety conditions at well sites, and greenhouse gas emissions.  It is the public then that bears the brunt of it as the true cost of fracking show up elsewhere in higher health care and climate change expenses. 

Keep in mind we are only discussing in this article efficiencies in the hydraulic fracturing process itself and not the larger matter of the total environmental costs of hydraulic facturing.  The same line of thinking also applies to the broader question.  As noted in the previous ‘scold post’ on January 3^rd, “New Year Resolution”, it is vital that analysts and investors begin to ask the tough questions of management.

What are the full costs of hydraulic fracturing?

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.