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From Fracks to Riches

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Despite all the hopes of sun and win enthusiasts, the real revolution in the energy world has been driven by old-style fossil fuels. Shale gas now dominates global energy policy.

by Stefano Casertano

Despite all the hopes of sun and wind enthusiasts, the real revolution in the energy world has been driven by old-style fossil fuels, not by renewables. Shale gas changed power relations in the fossil world, and its impact is going to affect economies and geopolitics. Unlike traditional natural gas, shale gas is not trapped in large reservoirs but in smaller rock formations that have to be penetrated through hydraulic "fracking." The drilling technology has been refined in the last twenty years and has allowed for extensive gas production in North America.

The price difference between (lower) American oil prices and (higher) European oil prices can be explained by the presence of shale gas in the U.S. The American WTI blend is some 20 dollars cheaper than the old continent's Brent blend.

Gas is no direct substitute for oil: It takes time and money to switch energy sources. You might want to get a good run out of your old car before switching to a new (and possibly gas-powered) model with better mileage. Or you might wait before switching your heating system at home from oil to gas.

But the fact that U.S. oil reserves can only cover some 45 more years of domestic need has already impacted the price of oil. The "Energy Information Administration" believes that the U.S. may even become a natural gas exporter by 2021. For the past five or six years, shale gas has been the new mantra of "energy independence" supporters. This is no GOP propaganda either. President Obama clearly included energy independence as a goal when he began his (first?) term in office, although the boom of shale gas is due to policies that had been introduced years before.

The dream of shale gas -- which environmental activists would describe as an ecological nightmare instead -- has also attracted the interest of other countries. China is thought to have large shale gas reserves, but the problem is the availability of water for fracking and extraction. Estimates put global shale gas reserves around 6,600 trillion cubic feet, most of it outside North America and much of it recoverable.

There is much talk about expanding shale business in Europe, even in France's Bordeaux region. When the idea was first mentioned, it elicited a laugh and a condescending look from the French. But Europe sits at the center of attention of the geopolitical debates surrounding shale gas. The shale revolution might weaken Russia's authority of the continent, as Europe would become less dependent on gas imports from Russia. It also links Europe to the United States: A portion of American shale gas might soon be exported using liquid natural gas technologies and would be shipped from the U.S. East Coast to European ports. Some say this may happen as soon as 2015. Moreover, Romania and Poland have shale reserves themselves, and their proximity to Russia adds further thrill to the geopolitical story. But as the reaction from Bordeaux reminds us, it remains to be seen whether the controversial drilling technology will be politically viable on the densely populated European continent.

Russia has already started suffering from the increased presence of gas in the international market. The increase in shale gas was accompanied by a reduction of demand for Russian gas exports, and prices dropped.

Natural gas in the U.S. is now sold at around three dollars per BTU (a unit of measure of gas), and Moscow was forced to revise its European policy of asking for ten dollars per BTU. This is no minor problem for the Russians: Because gas prices are partially indexed to oil, changes in the gas price will affect other energy sources as well. The Kremlin has estimated that it must be able to charge around 117 dollars per barrel of oil in 2012 to break even in the state budget.

Because of changes in the international energy market, Russia's "Ural blend" -- the Eurasian brother of Brent and WTI -- is currently priced at some 113 USD. According to Reuters a Russian government report concluded that Russia needs a Ural blend price above 100 dollar until 2015 to avoid defaulting. Similar issues are faced by Iran (break-even at 117 USD), Iraq (112 USD), Libya (117 USD) and Algeria (105 USD).

The U.S. keeps on dreaming: There's talk is about reaching total energy independence by 2030. It's a tempting vision, as the U.S. could finally avoid having to spend so much attention on the Middle East. In the 1980s, Secretary of State Alexander Haig was talking about Israel as the United States' world largest "aircraft carrier," that could not be sunk. For decades, the U.S. invested its efforts into sustaining the Shah of Iran (until his dismissal in 1979). Washington had to dedicate thousands of security meetings and billions of dollars to a region that spans from Pakistan to Morocco. Now, with shale gas, the burden has lessened.

Yet it is clear that the U.S. interests in the Middle East go way beyond oil and gas. And even if oil and gas were the only American interests, it would surely be unwise for the U.S. to leave the region's resources up for grabs. China, anyone?

The shale gas frenzy is reminiscent of the oil price crash in 1986. During his first day in office, on January 21, 1981, President Reagan canceled several oil price regulations imposed by the Nixon administration. New explorations were permitted or finally became profitable, and new oil began flowing from Alaska, the Gulf of Mexico, and even from the North Sea. In 1983, oil futures started to be traded on the Nymex, and the OPEC had to cede power over oil price control to the market. Demand collapsed due to the economic crisis started in the late '70s. By May 1986, the oil price had plummeted to below 10 U.S. dollars.

For exporters of oil, this was devastating. For ten years, at least until Operation Desert Storm in 1991, there was no talk about political plans of Saudi or Iranian leaders. The reduced inflow of hard currency also destabilized the USSR's finances and contributed to the 1991 collapse of the Soviet empire.

Some observers claim that the price bust was a deliberate U.S. strategy to impact Soviet finances -- notably, Peter Schweizer argues for this in his book Victory: The Reagan Administration's Secret Strategy That Hastened the Collapse of the Soviet Union (Atlantic Monthly Press). Yet the 1986 bust was just a consequence of free-market approaches whose impact on Russia was secondary. In the end, the situation had a negative effect on domestic US oil extraction industry as well. Vice President George H.W. Bush even flew to Saudi-Arabia to ask Saudi leaders to limit production and defibrillate the oil market.

This is yet another similarity with the current situation. Give the plummeting natural gas prices, service companies such as Schlumberger and Baker Hughes are not meeting their economic targets. Even Exxon is facing hard times -- and red numbers -- due to shale: In 2010, it paid 25 billion U.S. dollars to buy out XTO, a fracking company, and it appears unlikely that the investment will be recovered soon. Exxon's larger-than-life CEO Rex Tillerson admitted that investors are "losing their shirts" on shale. Some blame speculation and the free market for the oversupply and point the finger at companies like Goldman Sachs. It's too bad that Western leaders can't simply fly to Saudi-Arabia anymore, begging them to keep prices up.

This piece originally appeared in The European Magazine.