07/14/2011 03:17 pm ET Updated Sep 13, 2011

Natural Gas Pains

Not quite ten years ago, petroleum engineers hit on the idea of combining two well-known techniques -- horizontal drilling and fracking -- to make it possible to recover natural gas from shale rock formations. And the result was a bonanza of new domestic natural gas supply. Now, it seems that the bonanza may not be as great as its boosters hope. What's behind all this?

The standard geology textbook story about oil and gas goes something like this:
  • A lot of organic material gathers, say in a swamp, or at the bottom of a lake or ocean.
  • Through geological time, that organic layer gets buried under other rock.
  • Time, heat, and pressure turn the sand, dirt, and organic material into shale.
  • If one of the layers of overlying rock is hard and impermeable to water and methane, the shale will eventually "cook" until the oil and gas separates from the rock, forming the pools of oil and gas that we drill to exploit.

The problem, for petroleum geologists and engineers, is that the "just so" arrangement of rock strata is relatively rare. In the United States, we've been looking for and exploiting these formations since oil was discovered in Titusville, Pennsylvania, in 1859.

By the early 1970s, we were producing oil faster than we were discovering new oil formations. This phenomenon, called Peak Oil, was predicted in the 1950s by Shell geophysicist M. King Hubbert. Caltech's David Goodstein used similar theory to peg the "Hubbert Peak" for conventionally drilled natural gas at 1960. Worldwide new discoveries of natural gas have been in a very long term decline.

In all that time, most shale was not considered part of the reserves, because there was no way to produce natural gas from it. Until someone hit on the idea of putting together two techniques the petroleum industry used separately for decades.

In conventional oil and gas drilling, the well is drilled either straight down or at a slight angle, through the impermeable layer of "over cap" rock and into the pool of gas and/or oil. To produce the gas, the engineers put a section of pipe with lots of small holes through the pool of gas. Think of a garden soaker hose, but made of very hard steel instead of rubber. The idea is not for water to trickle out but for gas to trickle in. Then the gas goes up regular smooth pipe to the surface.

The problem with vertical drilling is that the productive formation is usually fairly thin, perhaps a couple of hundred feet at most. If it's thousands of feet below the surface, very little of the well pipe produces gas: most just gets it back to the surface.

To overcome this limitation, petroleum engineers learned decades ago to drill at any angle, including parallel to the ground surface. A formation that is only a hundred feet deep may be thousands of feet wide. So horizontal drilling can put far more "soaker hose" pipe into the productive formation, greatly increasing the output of the well.

When a well has been producing for a while, the natural pressure in the rock dissipates as man removes the oil or gas, and with it the natural pressure. The productivity of the well can be restored by pumping in material at high pressure.

Water is the obvious material, since it is abundant, cheap, and has the interesting property of being incompressible. You simply cannot squeeze water: instead you'll break the vessel. Or, in this case, the rock deep under the Earth's surface. Breaking the rock creates zillions of microscopic fractures, which provide more surface area for gas to diffuse out of the shale and into the collecting pipe. The mouthful "high pressure high volume microscopic fracturing" colloquially becomes "fracking."

Fracking has been used for decades to recover more oil and gas from existing wells. Modern fracking uses not just water, but a mix of organic solvents to mobilize even more of the oil and gas.

The game-changing insight was that horizontal drilling and fracking could be applied to produce gas from shale formations that do not have an overlay of impermeable rock. These formations are much larger. Shale seams may still only be hundreds of feet thick, but seams are known that are tens of miles wide and hundereds of miles long -- the remains of prehistoric lake bottoms and sea beds.

Once you find the formation and drill a productive gas well, you know almost to a certainty that the other wells you drill in the same formation will also be productive. This contrasts to the huge risks for conventional exploratory wells: a veteran oilman once told me that he expects 19 dry holes for every 20 wells drilled. The new natural gas odds are more like 19 producing wells out of 20 drilled -- if not better.

It is no wonder that the petroleum industry rushed to embrace the new techniques. Immense new useful reserves, located right in the Continental United States, with very, very little apparent investment risk - it seems almost too good to be true. And perhaps it is not quite as good as first hoped.

The general public became aware of the new natural gas production techniques through a series of incidents where fracking is blamed for unintended and unreimbursed environmental damage. Stories of local earthquakes attributed to fracking emerged from Maine and Louisiana. A town in Pennsylvania suffered release of radon from the ground that environmentalists blame on fracking. Fracking gets blamed by some for contaminating ground water and aquifers with nasty chemicals.

The debate on fracking already takes on political overtones, with people on the Left calling for investigations, controls, and penalties, while Right-leaning commentators dismiss such concerns. Hardening of the attitudes already seems to be setting in, and, as is typical in such cases, economic subtlety goes out the window.

If fracking causes environmental effects, society will bear the cost of those effects and their remediation. Whether the primary responsibility for paying falls on the producers, the victims, or the taxpayers, it is the taxpayers who are sure to be on the hook - if only because the losses reduce tax collections, even if taxpayers do not directly foot some or all of the bill.

At this stage, the one sure thing is that the business case for shale gas does not consider environmental remediation costs, whatever they turn out to be. That is one reason that the business case may not be as attractive as some people think, but it is very hard at this stage to estimate by how much.

A larger, or at least nearer-term, concern comes from reports that the productivity of the new shale gas wells is dropping faster, perhaps much faster, than expected. It is not clear what the physics and geology of this might be. But the business case implications are clear, and brutal: revenues will be less than expected over the life of the well, and costs will be higher as wells have to be re-fracked to restore production much sooner and more often than planned. In other words, the expected bonanza of profits is in peril.

With really very little data, I speculate that the inherent problem may be that the wells leak pressure much faster than the drillers expected. With no impermeable over-cap rock, water and pressure can escape from the shale - which is also how environmental contamination can occur. Drilling lots of wells in the same formation in relatively close proximity may speed the process somehow. Clearly, this line of speculation is beyond my expertise, so take these musings as what they are: the attempt of a reformed physicist to make sense of new data.

One other big issue looms over the picture. Demand.

The new techniques resulted in a huge increase in the US supply of natural gas. But nothing changed the demand. More supply, same demand - economists since Adam Smith tell us that the price must do down. And indeed it did. As the world economic crisis started to unfold in 2007 and 2008, the price of oil dropped by almost a factor of 2 from its peak, then recovered to about 70% of the peak price and well above the prices of the prior decade. Natural gas dropped a factor of 3 from its peak, and stayed below the prior decade average.

Investors used to assume that the price of oil and the price of natural gas where inherently linked, because they historically moved together. In actuality, the markets for oil and gas are quite separate, because it is virtually impossible to substitute one fuel for another over any short time frame.

Oil is almost entirely used for transportation: fueling cars, trucks, and airplanes. Only a relative trickle of oil goes into other uses. The bulk of natural gas is used to heat buildings; most of the rest is used to generate electricity.

A generation ago, MIT's Lester Thurlow pointed out that if it takes a capital investment of $10 to generate a new unit of energy, it takes a capital investment of only $1 to save that same unit of energy. Japan, California, and New York City increased living standards for decades without increasing energy consumption by investing in conservation measures more aggressively that other places. And there is no reason to believe that trend is played out.

So the demand picture is muted, and looks to stay muted for years into the future, even as more shale gas supply comes on line. It's not that the dogs don't like the dog food: it's that there aren't going to be more dogs. And thus, it could be that shale gas will look, as an investment, like other alternative energy sources: it will be harder, take longer, and produce less short term profit.

If I were a major investor in shale gas, there is one public policy measure that could help out, that would be better than direct tax breaks or subsidies: incentives to encourage early retirement of coal-fired electric generating plants. Burning natural gas, as opposed to coal, produces less CO2 for the same energy delivered. Natural gas turbines can serve as both base-load and peak-load facilities, where coal plants are only base-load. Gas turbines can be sited closer to loads, resulting in less transmission loss and better power availability. Other alternative energy sources like wind and solar would also benefit, but natural gas would likely get the lion's share. But it won't be a quick fix, for global climate, or for natural gas investors.