Energy Security and Shale Gas: U.S. Domestic Gas Policy Issues and Foreign Perspectives

Myles A. Walsh V

This dissertation is submitted in part requirement for the Degree of M.A. (Honours with International Relations)

At the University of St Andrews, Scotland, And is solely the work of the above named candidate.

April 24, 2015

Contents Acronyms i i i Abstract iv 1. Introduction 1

1.1 Essential Perspectives 1.2 The Novelty of Shale Gas 1.3 Topics for Discussion

2. Energy: Land, Wealth, and Capital 6 2.1 The Wealth of Nations

2.2 Harnessing Energy 2.3 Energy and Economic Growth 3. Energy Security and Natural Gas 12 3.1 Defining Energy Security 3.2 Dependence to Interdependence 3.3 Specific Issues for Natural Gas in the U.S. 3.4 Environmental Security and Gas 3.5 The Shale Gas Revolution 4. Challenges and Opportunit ies for U.S. Gas Policy 24 4.1 Tempered Optimism for Shale Gas 4.2 Natural Gas Value Chain

4.3 The Role of Government 4.4 Regulating Natural Gas

4.5 Analysis of Regulatory Approaches 5. Foreign Perspectives 36 6. Conclusions 40 Appendix A: Industry Terms 42 Appendix B: Graphical Representation 43 References 47

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Acronyms AEO (Annual Energy Outlook from the EIA) BP (British Petroleum) Btu (British thermal units) B/d (Barrels per day) Bcf/d (Billion cubic feet per day) CCS (Carbon Capture Systems) E&P (Exploration and production) EIA (U.S. Energy Information Administration) EPA (U.S. Environmental Protection Agency) EROI (Energy Returned on Energy Invested) FERC (U.S. Federal Energy Regulatory Commission) GDP (Gross domestic product) GHG (Greenhouse gas) IEA (International Energy Association) LNG (Liquid natural gas) LTO (Light tight oil) MENA (Middle East and North Africa) NG (Natural gas) NGL (Natural gas liquids) OECD (Organization of Economic Co-operation and Development) OPEC (Organization of the Petroleum Exporting Countries) R/P (Reserves to production ratio) Tcm (Trillion cubic meters)

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Abstract

This dissertation has been produced to research how shale gas fits into wider energy security perspectives for the United States, with a concise global perspective in respect to the U.S.. The focus in this paper on policy issues faced by the U.S. is in light of the recent ‘shale revolution’ in North America, which has been made possible by technological advancements, namely in ‘fracking.’ Energy security provides a necessary lens, through which to view government’s approach to the political, economic, and physical implications of shale gas and energy in general. A nuanced view of the policy issues presented by shale gas, in tandem with those faced in the broader energy spectrum is therefore constructed. The macro implications for the production of exhaustible resources are expressed in brief following the introduction to illuminate issues of economic growth and sustainability that constitute the current economic system. Increasingly limited returns to capital invested in production demonstrates how wider economic and environmental issues surface when unbridled ‘resource accumulation’ is the norm. Natural gas is no different than any other hydrocarbon in terms of its inevitable exhaustibility, but economic and environmental benefits in the mid-term may open a larger window for greater technological efficiency in energy to capital substitution. Regulation and policy can seek to make more efficient industry processes standard through competition and incentives, but they can also be disruptive forces. Yet, despite the hope that a resurgent gas industry brings, this paper concludes that at the macro level, countries can never have austerity in supply security policies as long as countries and companies continue to vie for access to global resources, and so long as exhaustible resources remain the main inputs of economic production.

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1. Introduction 1.1 Essential Perspectives

The most important figures to have at hand when trying to grasp the challenges

faced in maintaining energy security of supply in the global economy are those that

drive energy consumption levels, or rather those that deplete energy supply. The global

population is sitting at around 7.1 billion today and is climbing, where by 2030 global

populations is expected to reach 8.3 billion. Meanwhile, of that number the middle class

is set to grow by 1-2 billion in 2030 (BP Energy Outlook 2030, 2013). These 1-2 billion

people entering the middle class will demand more energy, as they are more likely to

drive and own cars, and eat meat (both energy intensive, and greenhouse gas (GHG)

emitting), in line with the status quo.

In light of growing demand, energy security has become an issue of increasing

importance for policymakers; the hazards inherent in relying too heavily on one fuel

type and on one region for supply require unique and flexible policy approaches.

Outside of the political reasons for resource diversification, environmental and

sustainability issues of fossil fuel reliance, make the search for alternative resources a

more necessary policy goal. This paper will not delve into the growing need for

alternative resources, but will touch on issues of environment and resource

exhaustibility in respect to shale gas production and broader energy security discourse.

The end for hydrocarbons may not be as close, or as sudden, as M. King Hubbert’s peak

oil predictions once suggested. Hubbert predicted oil productions decline in the U.S. in

the 1970’s, but he of course could not have predicted the technology developments that

have caused production in liquids and gas to increase once again (Hubbert, 1956). Even

though gas production has dramatically increased in the United States in the past

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decade, most of production fuels domestic demand, and the global market for oil

regulates price.

Predictions from the U.S. Energy Information Administration’s (EIA) Annual

Energy Outlook (AEO) 2014 demonstrate that oil continues to be a substantial part of

the energy base for years to come, declining slightly to just above one third of U.S.

domestic consumption.1 Natural gas production is predicted to continue to grow in real

terms, and as a share of consumption, but this increase only serves to offset rising

demand. Analysis from the EIA demonstrates that increases in U.S. domestic

production of liquids have reduced net imports from 60% (2005) of total consumption

to 40% (2012), and by 2040 expectations are for just over 30%.2 Despite this abundance

in both liquids and gas, the costs of production continue to increase as a result of

exploitation of more capital-intensive plays. Limits to returns on capital investment are

a reality that must be dealt with by policy in order to incentivize production at higher

costs. The dramatic increase in production in shale gas has been made possible by

favorable regulatory policies that deregulated prices and incentivized upstream

investments.3 For natural gas, reserves are higher than ever thought before, but

resources are limited and a number of factors must coalesce to make continued

production viable.

1.2 The Novelty of Shale Gas

The shale gas revolution’s novelty is in its unpredicted abundance, and in

technological advances, which have enabled the exploitation of unconventional

hydrocarbons in the United States that were previously inaccessible and uneconomical

1 See Appendix B: Figure 1. “U.S. primary energy consumption by fuel, 1980-2040 (quadrillion Btu)” 2 See Appendix B: Figure 2. “U.S petroleum and other liquid fuels supply, 1970-2040 (million barrels per day)” 3 See Appendix A: ‘Upstream’

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to produce. There is still variance in economic feasibility between shale gas plays, and

‘tight gas’ plays require far more stimulation from fracturing than shale, due to the

relative impermeability of the reservoir rock from which it is sourced. This research will

be centered on shale gas production, because of the scale of operations in shale

formations. More permeable shale has enabled production of natural gas to increase by

approximately 50% from 2008-2012. Shale gas as a percentage of U.S. gas production

rose from just 5% of total production in 2007 to 39% in 2012, and is still climbing

(Blackwill & O’Sullivan, 2014). That said, unconventional plays vary in viability and

locale, and this can create very local and specific issues for policy. Energy policies in

the hydrocarbon era face the same systemic challenges that are embedded in all

exhaustible resources.

Such a boom in gas production may be extremely difficult to replicate globally,

because of the specific convergence of conditions in the United States that has made

production viable. One of the most unique aspects of the United States’ extractive

industries is the country’s private land ownership, whereby landowners conceivably

own all mineral resources beneath their properties and therefore have an incentive to

make their land economically productive. This alone generates incentives for a range of

economic activity involved in exploration and production (E&P). Furthermore, the

advancements in hydraulic fracturing (fracking) and horizontal drilling technology,

have demonstrated the impact that technological advances have in creating new

opportunities and concerns for policymakers.4 This technology combination,

implemented first in 1986 by George Mitchell for use in the Barnett shale, has only

become viable in the past decade (Warner & Shapiro, 2013). Advances in the

technological capabilities and efficiencies of drilling and well stimulation, coupled with

high oil prices, have made extraction of gas from previously inaccessible plays of low

4 See Appendix A: ‘Hydraulic fracturing (Fracking)’ and ‘Horizontal drilling’

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permeability viable. For shale gas in the U.S., pre-existing distribution networks, and a

number of established wellbores enabled quick returns on new technology investments.

Despite the considerable investments in upstream businesses for natural gas, the

industry has at times been bottlenecked by a lack of investment and commitment in

midstream and downstream processes.5 Pricing instability, government controls, and

uncertainty deters large long-term investments in distribution, services, and utilities.

Wider usage of gas requires more robust markets and incentives in mid and downstream

gas infrastructure.

1.3 Topics for Discussion

Energy security provides an essential lens through which to view international and

domestic affairs. Focusing on natural gas will demonstrate issues that are faced in

attempting to manage the production and supply of a specific source of energy, and the

importance of technological advances in increasing efficiency. A detailed look at the

natural gas industry in the United States in light of the shale gas revolution will

demonstrate the dynamic role that government plays in developing policies to promote

reliable sources of energy. In terms of shale gas, the government faces the challenge of

balancing state and federal controls, in order to ensure that the risks involved in

upstream and downstream businesses are recognized and dealt with, and that the

management of essential value chain operations are not left unchecked.6 The following

chapter will seek to provide a theoretical insight into how and why hydrocarbon usage

is embedded into the global political economy, in an attempt to establish the crux of

energy security. This will touch on issues of growth, and the historical economic

progression of energy. The paper will proceed to address the importance of energy

security, centering on current energy security literature, and then the dimensions of 5 See Appendix A: ‘Midstream’ and ‘Downstream’ 6 For a flowchart of the natural gas business physical value chain see “Appendix B: Figure 3. Natural Gas Physical Value Chain.”

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shale gas from an energy security perspective. The more efficient policies (from an

industry standpoint) that have enabled the resurgence of U.S. domestic production will

then be reviewed with a look at U.S. policies surrounding fracking and their

implications. The final chapter will address international issues of energy security and

shale gas with deference to the United States. A better understanding of energy security

and of the ‘shale revolution’ from a U.S. energy security policy perspective is the

primary goal of this research.

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2. Energy: Land, Wealth, and Capital

2.1 The Wealth of Nations

The major sources of energy throughout history have defined and driven the

level and nature of wealth in the global economy. Energy from hydrocarbons has not

always taken such a grand stage in global affairs, or in human affairs for that matter.

Where land was once the primary source of wealth, now capital, which is a means of

using energy from hydrocarbons for the production of goods, determines wealth (Hall &

Klitgaard, 2012). The theoretical underpinning in economic history will provide a better

understanding of why energy sources like gas are so essential throughout the global

political economy and therefore take precedent domestic governance. The role of

energy in the global political economy can be traced back to the foundations of

economic study. From the physiocrats, to classical economists, and now in neo-classical

and neo-liberal economics, the major energy sources of the time have been the

economic drivers for asset accumulation. They are the physical sources imperative for

economic production and wealth accumulation. In the 18th century French physiocrat

tradition the fundamental origins of wealth came from the use of land in the form of

agriculture, husbandry, and timber (Cleveland, 1999). Mercantilist governments

implemented controls and tariffs on imports and exports in order to create an

advantageous balance of trade, thereby constricting growth in the global economy. In

mercantilism, colonialism was the tool through which states accumulated the resources

needed to literally fuel the economy; further controls were placed on domestic

production of goods as well as on the export of gold and silver bullion (Ravenhill,

2010). This was the constrictive manner in which states sought to secure the factors of

production and accumulate wealth. With the physiocrats, and then classical economists,

the idea of more efficient natural and ‘laissez-faire’ economies took shape.

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For classical economists, increased efficiency was recognized in the divisions of

labor, and the creation of industrial technology. Labor is the process by which human

and machine energy work is put into raw materials to generate wealth. This realization

led Adam Smith to surmise towards the end of the 18th century that the wealth of a

nation originated in labor (Gilpin, 2001). Following the industrial revolution, the

division of labor became more pronounced, and as efficiency increased, the benefits of

specification in the labor force and in industrial production are recognized in economic

study. Classical economist David Ricardo’s theory of comparative advantage

demonstrates the issues inherent in mercantilism, and the need for optimal efficiency in

the global economy. The economic roles for states in the global economy are based on

their material capabilities according to Ricardo, and in market economies production

efficiency is dictated by costs of production as a result of the raw materials present

(Gilpin, 2001). Therefore, placing restrictions on economic liberalization in the form of

barriers to trade is counterproductive to wealth creation in the global economy.

Efficiency at the systemic level is fostered by economic liberalization between states

and the advancement of free trade dictated by comparative advantage. Indeed self-

regulating economies distribute wealth more efficiently, and more wealth is created as a

result of this efficiency. The point remains, however, that underpinning historical

economic progression is not individual utility maximization, the accumulation of

material capabilities by states, or solely technological advances. Instead it is in increases

in the efficiency of transforming the factors of production: natural capital (goods and

resources), physical capital, and labor, into higher quality goods (Murphy & Hall,

2011).

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2.2 Harnessing Energy

Modern forms of energy have facilitated vast population growth, and are the

primary factors of production for the global economy. From a thermodynamics

standpoint, the law of conservation dictates that mass input must be output, meaning

that energy is required in all transformation of matter. Energy cannot be created

(because matter cannot be created), and can only be used more or less efficiently (Stern,

2004). For humans, survival has always been dependent on harnessing energy from the

biophysical sphere, first as hunter-gatherers, then subsistence farmers, as traders, and so

on. At the macro level, technology has proven far more efficient than biophysical, or

trophic processes, in terms of energy transfer, and to a degree survival has become less

of concern for humanity collectively (Hall & Klitgaard, 2012). Today’s energy

landscape is made possible by efficient transferring mechanisms for turning primary

energy sources such as solar radiation and fossil fuels into more useful energy carriers

such as radiant heat and electricity (Murphy & Hall, 2011). Inefficiency translates to a

loss in capital and gross domestic product (GDP) in the current global political

economy, and this is the plane on which states operate in the neoclassical economic era.

An essential way to look at energy production is in terms of energy returned on energy

invested (EROI), a numerical figure that demonstrates the net value of an energy source

and determines viability of production (Murphy & Hall, 2010). Increases in energy

returns are determined by human and technological capabilities, and physical realities.

In EROI considerations, an important aspect missing from most calculations are the

energy implications of negative externalities. These include energy costs of

environmental destruction, and the opportunity cost of not investing in green

technologies. Still, for photovoltaic cells for example, the reason for limited application

is the technology’s inability to compete without subsidies. The reason for higher costs

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is the inefficiency of the technology due to intermittent sun, limited energy storage

capabilities, and interface inefficiency (Denholm & Margolis, 2006).

2.3 Energy and Economic Growth

The production of hydrocarbons allows for the transfer of matter via energy into

capital. Capital is defined by both monetary value, and the value of physical assets.

Energy consumption literally fuels the states’ push for capital accumulation, and

therefore economic growth (Murphy & Hall, 2011). Indeed, in order to ensure energy

security of supply, states must acquire the wealth of resources to match domestic energy

consumption levels. More often than not this has led to a focus on quantity of resources,

rather than efficiency of use. As demand grows, states look abroad to countries that

possess reserves of primary energy sources. Indeed, states are motivated at least in part

by self-interest, and don’t always possess the materials they need or want to feel secure,

which can lead to conflict and inequitable distribution of resources. The policies of

energy security have largely been driven by resource accumulation, from which the

foundations of social economics have arguably never departed. The continued influence

of neo-classical economics on state economic policies fuels Realist foreign policy

considerations, in which relations revolve around material capabilities. The work of

ecological economists however has sought to demonstrate how growth and even

sustainability at current levels of material consumption is problematic given the lack of

attention given to resource exhaustion and technological limits on substitution of energy

inputs for capital.

In typical economic growth applications which generally rely on Robert Solow’s

growth model the focus of neo-classical economics on capital accumulation neglects the

importance of physical inputs and outputs, and imagines a world in which potential

consumption has no ceiling (Stern, 2004). Solow’s model does not include resources

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whatsoever, and the ratio between capital and employment determines efficiency of

output. Economic growth theories generally hold that because capital can be used to

make more efficient technologies, for more valuable uses and products, then there is in

effect no limit to the rate of return on reinvested capital in the long run. This then leads

to higher and higher economic equilibriums (Solow, 1956). Solow was not blind to the

issues with his growth theory though, and put forward the caveat to his initial work that

production of finite resources can only increase unrestrained if there are no costs of

producing the resources (oil, coal, gas) that produce energy (Solow, 1974). Under

neoclassical economics technological transformation cannot be explained and progress

conceivably has no limits. The laws of thermodynamics clearly place limitations on the

substitution of energy for capital, and even the most efficient technology imaginable

would require energy inputs (Stern, 2004). Current economic goals of capital

accumulation and the notion of linear trending economic growth are indicative of

flawed ontological assumptions in modern economic thinking, which neglect the reality

that there are limits to substitution between energy resources and capital. Efficiency of

energy substitution for capital does not create wealth, but simply transfers it to a more

serviceable social form.

Growth, via technological change, has resulted in more resource use, rather than

less, because there has not been economic incentive enough to reduce energy use (Stern,

2004). The danger in relying on neoclassical economic theory to understand energy

supply security is that the underlying assumptions in free market economics further

engender self-interested and unsustainable consumption practices. These assumptions

implicit in neo-classical economics are based in principles of self-interest. Viewing

consumers, and for that matter states, solely as utility maximizers, and equating

financial profit to utility, creates a self-fulfilling domain in which capital becomes more

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important than value (or quality of living), and for that matter survival in the long-term.

Indeed, as David Stern writes:

“The fear is that excessive substitution of human-made capitals for natural capital will cause the system to approach a threshold beyond which natural systems will lose resilience and suffer catastrophic collapse” (Stern, 2004, 43).

The reason for maintaining the status quo is found in the realization that “in the long run

we are dead,” as economist John Maynard Keynes has recognized. As a result there is a

generational amnesia endemic to economics and by extension government policies.

Self-interest becomes the norm in the short term as a result of the tumult of boom and

bust cycles (Miller, 1999). The reality remains that the supply of energy currently

fuelling the modern economic machine is finite, and states still struggle for position in a

zero-sum game. Proponents of economic liberalism may prescribe free trade, and

international institutions as a way of managing scarce resources, but in reality there is

no clear path, no theory, for ensuring the survival of billions and their progeny. This is

especially the case in light of the rise of neoliberal economic practice in which private

entities control the factors of production, and therefore energy. It is important to realize

that neoclassical economic principles are the foundation for current economies, but that

energy concerns question the integrity of the entire system. The role of policy is limited

by economic systemic realities. In terms of energy security, policy alone cannot hope to

alter the status quo of the economic system, but instead policy’s role is increasingly to

manage risk.

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3. Energy Security and Natural Gas 3.1 Defining Energy Security

Before addressing how natural gas factors into energy security considerations, it

should be noted that there is no single definition of energy security. Energy

requirements and capacities are diverse and vary from country to country. Equally the

concept of security is just as variable (though there is scant discussion of varying

security paradigms in literature), but it is portrayed as an aspect of national security

considerations in most readings. Energy security literature widely holds that in the

absence of a unifying energy policy governance body, governments ultimately dictate

energy policy priorities. Fear of further shocks to international oil markets has

motivated a vast and continued effort for political action and the development of

economic buffering mechanisms to price and supply shocks. Studies do not delve into

how policymakers, regulators, etc. should attempt to predict possible future shocks and

disturbances, but rather focus on crises management. They present strategies to evaluate

current and past policy situations, towards mitigating risk. The need for long-term

policy strategies, in tandem with the inevitable need to respond to developments is

problematic, and there is no clear-cut answer for how to manage this risk. In his

working paper that gathers and analyses multiple definitions of energy security,

Christian Winzer assesses definitional parities and commonalities, concluding that

energy security is endemic to the entire supply chain. He asserts that energy security is

characterized primarily by prevalence of threats, and a state’s ability to mitigate or

respond to threats to the supply chain. Winzer also notes that a side effect of energy

security’s increasing relevance, and lack of definition, is its frequent invocation as a

tool to justify a variety of policy goals (Winzer, 2013).

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On this subject, Joskow writes:

“There is one thing that has not changed since the early 1970s. If you cannot think of a reasoned rationale for some policy based on standard economic reasoning then argue that the policy is necessary to promote ‘energy security’” (Joskow, 2009, 11)

Energy security policies and concerns are emotive because they involve the very factors

of production on which the current status quo of economic growth is dependent. The

linking between state security and energy security elevates energy policy.

3.2 Dependence and Interdependence

Discussions of threat are typically centered on dependence and finding ways to

mitigate it. This can entail reducing dependence on a single fuel source or a single

exporting country or region, in an effort to minimize shocks. Particularly prevalent

problem areas that are identified in literature are reliance on resources from

geopolitically unstable areas, specifically oil from MENA, and gas from Russia.

Additionally, regional dependence of consumers on limited sources for pipeline natural

gas gives monopoly-pricing power to suppliers (Kalicki, & Goldwyn, 2013, 6). The

growing interdependence between countries, and growing integration in energy

industries calls for global energy markets. Bordoff writes that the biggest problem with

oil is not that it is imported, instead it is the macroeconomic and national security

constraints of heavily relying on a single commodity (especially in transportation which

directly effects household budgets) (Bordoff et. al, 2010, 212). In this sense, it does not

matter where the oil originates, but rather it matters that the U.S. relies on a commodity

that is globally priced.

Research on energy policy issues with an international security focus was

proliferated by the oil crises in 1973, and in 1979. Daniel Yergin has been a leading

thinker in energy security policy, and his 1973 article in Time magazine, brought energy

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security issues to the attention of policymakers. Security of oil supply remains at the

forefront of energy security concerns, but increasingly, the breadth of policy discussion

incorporates concerns of non-oil sources, and perspectives that reflect globalization and

interdependence. The 1973 OPEC Oil Embargo demonstrated the widespread impact

that geopolitical events, manifested in price shocks, could have on security of domestic

oil supply and oil market confidence. The need for national energy policies to

incorporate international security concerns quickly became evident in light of this

(Yergin, 1973). Awareness of the critical nature of energy supply security, have led

every U.S. president from President Richard Nixon to President Barack Obama to

espouse ‘energy independence’ as an economic security goal, even as import

dependence has continued to increase. Current literature widely debunks ideas of energy

independence as unrealistic (Deutsch, 2010a; Yergin, 2006). Indeed, in his inaugural

address in 2008, President Obama outlined energy independence as one of the main

policy goals for his presidency. President Obama though has tempered his rhetoric, and

has moved away from the idea of independence in energy. Now with increases in

domestic production having little impact on buffering global volatility, the realization

follows that the economic fates of nations are more or less tied together in the

globalization of world markets. In June 2014, speaking about shale-gas production in

relation to climate, President Obama acknowledged: “We should strengthen our

position as the top natural gas producer because, in the medium term at least, it not only

can provide safe, cheap power, but it can also help reduce our carbon emissions”

(Yergin, 2013b). Gas will be discussed in the next section, but President Obama’s

statement is emblematic of the growing shift in energy security policy towards the

recognition that supply diversification can only do so much when exhaustible resources

are the primary energy inputs.

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According to Yergin in his 2006 Foreign Affairs article, titled “Ensuring Energy

Security,” the guiding principles of energy security policies can be compressed into four

sub categories, first and foremost being ‘diversification,’ then ‘resilience’, integration of

systems, and quality and presence of information (Yergin, 2006). The call for integrated

best practices throughout the supply chain, and the importance of making informed

decisions given long-term horizons, requires transparency between governments and

companies across supply chains. This harkens back to the point that because energy

form constitutes the economic system, all those who rely on it are thereby

interdependent both on the supply side and the demand side. The juxtaposition between

Yergin’s analyses of the initial oil shocks in the 1970’s, which was born out of crisis, to

today’s proactive scenario based policy considerations, reflects the progression of

energy security. Yergin also asserts that the importance of recognizing the impact of

globalization and of complete security across the supply chain has increased in

importance. Across all energy security literature diversification of supply is presented as

the primary method of enhancing security of supply. Fear of severe economic

consequences, inhibits government to change the way in which society uses energy, and

therefore policies are set around management of growing demand, and supply

uncertainty. To diversify energy portfolios, and limit the negative effects of oil supply

shocks (and increasingly other commodities), policies can be aimed at diversifying

energy sources (importing from numerous countries) as well as diversifying energy type

to gas, hydro, coal, nuclear, etc.. Not far removed from principles of ‘diversification,’

‘resilience,’ Yergin proposes— can come in the form of “spare production capacity,

strategic reserves…as well as carefully conceived plans for responding to disruptions

that may affect large regions” (Yergin, 2006, 76). These disruptions may result from

natural disasters, geopolitical events, or other unexpected events. Supply dependence is

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more a function of systemic realities, and is better characterized as a wider

interdependence between the consumers and producers of exhaustible resources in the

global political economy, rather than by the nature of a single fuel source or region.

3.3 Specific Issues for Natural Gas in the U.S.

For the development of a more global and integrated natural gas market that is

both secure and less constrained by oil prices, the United States must lead the way in its

efforts to balance state security with the requirements of industry. That said, there are

specific constraints for each country, as will be made evident in further chapters.

Adoptions and transferals of policies are difficult because of varying energy security

realities across states. The ‘shale revolution’ in North America has been made possible

by high and stable global oil prices, and a favorable regulatory climate. Still, oil price

manipulation vis-à-vis changes in production by exporting countries can have adverse

effects on natural gas and liquid natural gas industries—sidelining projects, and

reducing investments. This presents a particular obstacle to security of supply for

natural gas. For countries like China, with abundant reserves and an emerging economy,

domestic natural gas production could help meet growing national energy demand.

However, appropriate policies and aboveground investments (both upstream and

downstream), must be made to support and encourage continued investments in E&P.

The primary questions at present are: What is the role of the United States in managing

natural gas production? Are the concerns of natural gas far removed from those of

broader energy security?

Following the first oil shock in the 1970’s, regulations aimed at stemming

supply shortages across the United States combined with further shocks exacerbated

industry ailments. Energy security discourse has been centered on oil, but now is

producing more discussion on emerging economies, natural gas, and sustainability.

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Discussions surrounding abundant unconventional shale gas development in the United

States more recently deal with regulatory issues, economic prospects and environmental

externalities. The section addressing previous periods of natural gas scarcity in

Joskow’s 2013 article displays the susceptibility of the gas industry to price

manipulations, and the deleterious effects of regulation. Joskow’s study demonstrates

the need for flexible regulations to create lasting and robust natural gas markets and

infrastructure. Basing regulations on short-term fluctuations between scarcity and

abundance leads to ineffective policy, which further exacerbates market volatility.

Research cannot hope to pin down all future hazards to energy security;

nevertheless, the role of gauging the impact, and severity of events/risks in unison with

efficacy of policies is managed through the creation of predictions and future scenarios.

Authors have pointed at availability, reliability, and affordability as the keys to

determining future elements of security (Yergin, 2006; Elkind, 2010). From Energy

Security, Ann Florini writes in her chapter “Global Governance and Energy,”— energy

security may be defined as “reliable and affordable access to energy supplies” (Florini,

2010, 151). It is through this lens that predictions are analyzed and created. Predictions

and scenarios play a large role in shaping policies, and a heavy reliance on predictions

can entrap countries, and companies in detrimental behaviors. The majority of these

scenarios and predictions come from the OECD’s International Energy Agency (IEA),

the (EIA) and organizations such as ExxonMobil, which produces an annual Outlook

for Energy (Newell & Iler, 2013, 28-29). Victor compares AEO predictions from the

EIA for gas wellhead prices with real prices, and finds that the speculations grounding

contracts (often long-term) from 1993-2010 have been largely ineffective at making

accurate predictions. Victor writes that the EIA’s predictions are widely relied on for

many contracts, but that in light of shale gas these predictions have proven largely

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reference based and have lacked the capacity to predict market changes (Victor, 2013,

94). Dependence on one source for scenarios can leave policy-makers more vulnerable

to unforeseen developments, or less willing to accept conflicting information as it is

presented, and therefore less capable of adapting. This serves as a clear caution that

organizations are just as ill equipped as states are in dealing with global governance

issues in energy. There is no institution equipped to manage and secure the multifarious

arms of the energy industry. The general sentiment is that policies should not be built

around energy outlooks, but rather these predictions should be used to understand how

underlying critical assumptions might change energy security policy realities.

3.4 Environmental Security and Gas

A further development in energy security literature is increasing concern over

anthropogenic climate change and the negative externalities of fossil fuel use. As a

result environmental sustainability has become a topic of discussion for energy security.

Jonathan Elkind proposes that in addition to the traditional three elements of energy

security, a “contemporary definition” must include a sustainability element of energy

security (Elkind, 2010, 128). Deutch develops a whole chapter on how to address the

need for “transition from an economy based on fossil fuels to an economy on nuclear

and renewable energy sources,” as he cites dependence issues with oil imports and

‘burning fossil fuels’ as imperative to national security (Deutch, 2010a, 79). Reference

to energy security is useful in motivating environmental reform, which is in line with

Joskow’s 2009 comments on the effectiveness of utilizing energy security concerns in

promoting other policy issues. Increasingly more deference is being given to energy

concerns in security policy and additionally environmental issues are factoring more

heavily into policy considerations than they ever have before. Elkind cites the need for

long term considerations when building infrastructure as a main reason for growing

19

focus on energy systems impact on the environment. Indeed, concerns over

environmental impact are increasingly prevalent in building infrastructure for natural

gas. Pipelines are required to span across the country, and as increasingly remote wells

are tapped at greater frequency, the options of rail or freight movement appear less

economic than pipelines (Elkind, 2010, 129).

Concerns about natural gas’ environmental impact could stand to hobble the

industry if regulations are not put in place and public fears quelled. Still as President

Obama remarked, there are mid-term benefits for the use of gas. In fact, “natural gas is

still the cleanest source among fossil fuels” says the IMFs World Outlook report from

October 2014 (Rabh, et al., 2014, 26). To further promote the industry of gas and the

boom of shale production, natural gas is being labeled by many in policy circles as a

‘bridge’ fuel rather than as a long-term energy solution as some in the industry believe

it to be.7 As a ‘bridge’ to lower carbon fuels, natural gas is viewed as a means of

sustaining demand until alternative sources are more efficient and able to be produced

at scale for lower cost (Kerr, 2010). For natural gas, environmental concerns revolve

around methane gas leaks and fracking fluids causing air and groundwater

contamination. Still there is contention in science and in industry over the causality of

polluted aquifers, with companies generally denying responsibility. Though the jury is

still out on the magnitude of fracking’s environmental effects, anecdotal evidence

suggests that water supply, GHG production, and seismic activity are among the top

concerns. States like Colorado though, are leading the way in identifying economically

viable safeguards to stimulate environmentally friendly best practices in fracking.

Further argument for federal legislation and regulation, cites the need for more

transparency in the disclosure of the chemicals used for fracking and in establishing

7 In policy circles natural gas has been termed as a ‘bridge’ to a cleaner more efficient future of energy, rather than a long-term solution.

20

best practices, which are currently protected by proprietary rights (Beebeejaun, 2013;

Davis and Hoffer, 2012). Throughout his works, Yergin presents environmental issues

as being up for “debate,” leaning on extractive industry capabilities and expertise to

deal with environmental concerns. In regards to fracking for natural gas, Yergin

recognizes and acknowledges the problems with chemical and methane laced “flow

back” fluids, as well as the need for proper handling and management of waste. Still, he

advocates state based regulations (which are highly motivated by individual companies

and interest groups) rather than wider federal ones for the United States (Yergin, 2011,

330-332). This will be discussed more at length in Chapter 4, but Congress relinquished

control over fracking regulations to be dealt with by individual states in 2005 (Davis

and Hoffer, 2012).

In his 2013 article, Joskow writes that there is little evidence and documentation

that shale gas development has caused the release of methane into ground water, but

rather it is more likely that the issue has arisen from “shallow conventional gas deposits

that are disturbed during the vertical drilling process” or some other such malfunction

closer to the wellhead (Joskow, 2013, 342). It is clear that more study needs to be done

on the environmental impacts of shale gas, especially if these technologies are to be

implemented across the world in areas where water resources are more scarce (i.e.

Northern China). Specific state based regulations make sense because of the variability

in the United States of natural gas distribution and production. Yergin’s preference for

localized authority however still reflects his industry-oriented view that responsibility

should lie with industry rather than the Federal government, because less restriction

motivate quicker development (which is not always prudent). For government and

industry, environmental issues have not been until recently, a motivator for energy

security policy but rather an inhibitor to security of supply-based concerns. Though

21

Yergin is less keen on broader Federal regulations, both Yergin (2013b) and Joskow

(2013) advocate that best practices are necessary to reduce risk of impact to the

environment regardless of causality. Despite a lack of scientific proof, political activist

groups do not hesitate in denouncing fracking as an environmental evil, and the benefits

of the fuel as a mid-term alternative become overshadowed.

3.5 The Shale Gas Revolution

Before the “Shale Revolution” in which natural gas production from shale rose

by 471% between 2007 and 2012 (CME Group, 2014), the focus of energy policy

literature on natural gas in relation to North America was on scarcity and the potential

for development of LNG imports. Increased production was unexpected (Yergin, 2013;

Victor, 2013). A rise of investment in regasification facilities along the East Coast

predated the boom, and given the fixed costs involved, these are now forced to run at

diminished capacity (Foss, 2005). The rise in LNG import prospects had seemed to

indicate a trend towards global gas markets, and more standard consistent pricing

mechanisms. Today global gas prospects are being stimulated by abundance, and hope

for significant production in the United States and elsewhere. In competition with oil,

analysts point at the ‘BTU per $1’ output to value ratio that has tipped in the favor of

natural gas post-2008 (Deutsch, 2010b). This speaks as an indicator of the favorability

of natural gas as a substitute for oil (CME Group, 2014). Prior to the dramatic increase

in domestic production, natural gas was projected to slump in North America because of

“rising demand and constrained supplies” (Yergin, 2006, 70). The regasification plants

that had been largely unused along the U.S. East Coast are now being retrofitted for

liquefaction, and are gradually being granted status as LNG exporting terminals. Lack

of foresight might have slowed the ‘shale revolution’ if it were not for the hospitable

regulatory climate, and advances in technology.

22

Scholars and analysts point at technology developments in unconventional plays

as having the largest part in turning energy supply outlooks from scarcity to abundance

in the United States. In 2013 Yergin identified the transformative nature of natural gas

to energy security policy considerations:

“The very concept of energy security is taking on a wider meaning. No longer does it mainly encompass just the flow of oil, as central as that is and as has been for four decades. Natural Gas was formerly a national or regional fuel. But the development of long-distance pipelines and the growth of liquefied natural gas have turned natural gas into much more of a global business” (Yergin, 2013, 70-71).

Yergin, who has a clear stake in the proliferation of hydrocarbon based energy markets,

exaggerates the true global reach of oil here, when in fact most of business remains

primarily regional. Under the right circumstances, novel natural gas extraction methods

(fracking) are poised to contribute to economic growth in countries with shale gas

reserves. Fracking is a relatively new and embroiled issue for policymakers, because of

the nuances in its domestic and international energy security implications. A focus in

the literature has been on how natural gas as an industry is becoming more global in

nature, but there remain clear obstacles to a global market. The oil industry’s advantage

lies in its monopoly over the transportation sector in the US, the existence and ease of

use of pre-existing distribution infrastructure, and its competitiveness with LNG. Gas

electricity plants have a leg up in terms of energy production because of their

advantages over those running on nuclear and coal. Gas is cleaner than coal, and does

not polarize consumers the way nuclear does. Indeed coal is being displaced at a fast

pace in the U.S. by natural gas in electricity production, and will continue to do so.8

Coal maintains its advocates in those seeking to develop efficient carbon capture

systems (CCS). But this research has wasted billions of government dollars, on a

8 See Appendix B: Figure 4. “Electricity generation from natural gas and coal, 2005-2040 (billion kilowatt-hours)”

23

technology that is energy inefficient, and such funds would be better allocated towards

research in sustainable efficient technology (Kenderdine & Moniz, 389). As a result of

reduced domestic consumption, more coal than ever before is being exported, but this

provokes a quandary, seemingly counterintuitive to environmental aspects of energy

security, as carbon emissions are exported to poorer developing countries.

Even with high expectations for gas resource levels there is uncertainty

surrounding how exogenous factors will affect domestic markets. There are no analysts

that claim that natural gas is the best thing out there for the environment or the

economy, but it is available now. Additionally an article in Science on shale gas

advancements presents the argument that more production will only serve to lower costs

and increase consumption levels (Kerr, 2010). However there are real benefits to

increases in production, and lower costs, including job creation across the entire supply

chain and in countries where gas is currently relatively expensive—in turn helping to

unify markets and prices (Victor, 2013). Still it is important to temper expectations, and

remain wary of the many factors that can potentially affect the security of energy

supply.

24

4. Challenges and Opportunities for U.S. Gas Policy 4.1 Tempered Optimism for Shale Gas

The natural gas boom has been touted as a saving grace for the American

economy and there is indeed much reason for optimism. Manufacturing jobs are

returning because of reduced costs of energy and of raw materials. Simultaneous light

tight oil (LTO) drilling from shale allows for increased profit and makes more plays

economically viable. From the refining of natural gas liquids (NGL) from shale,

chemical companies are able produce cheap monomers such as ethylene, which are

needed to produce plastics, and add significant value to manufacturing capabilities in

the U.S. by simultaneously reducing material costs and increasing supply (Gellrich,

PWC, 2011). As a result of abundant shale, more jobs are being created in energy

businesses and indirectly from reduced operating costs. Yet, as has already been

expressed, the benefits of increased production of natural gas, and of hydrocarbons in

general are full of caveats. In unconventional resources outside of natural gas for

example, although LTO is bountiful in shale formations, the United States has limited

refining capacity for this fuel grade, while refineries are instead built around heavy

crude refining. This presents policy issues surrounding the export of LTO from the

United States and import of heavy crude, in order to increase efficiency and optimize

the downstream industry in line with comparative advantage. Natural gas can help

reduce costs and make LTO refining possible on the US Gulf Coast, but prices must still

fall for LTO to displace crude in refining. Government subsidies would decrease value,

and increase the price of heavy crude, which would have a negative impact on the

balance of trade. On the other hand if the ban on exports were lifted greater capacity

efficiency for refineries, would be the result (Inglesby et. al, 2012).

25

4.2 Natural Gas Value Chain Foundations

The extraction and distribution of natural gas is capital intensive, and requires

long-term commitments by industry and government. In the United States private

companies carry out production, and it is in the interest of the government to ensure that

these companies have incentives to operate. For production to occur in a market-based

economy, it must be profitable. Thus, present values of revenue must be proven to be

greater than that of the total cost of production. The extent to which costs are equitably

apportioned throughout the value chain, and through to the consumer is dependent on

both regulatory framework and market conditions, and has direct effects on price

volatility and consumer confidence. Reducing market volatility is an inherent policy

aim of democratic governments with high levels of domestic gas production, because it

provides more security for investors at all levels of the value chain. Volatility is often a

result of exogenous factors to production capabilities and domestic supply, such as

political and economic disruptions in major hydrocarbon producing countries. By

limiting margins on earnings and facilitating corrective pricing mechanisms to support

the market, regulations can help to dampen price volatility (Weijermars, 2010, 93). It is

also extremely important that government manages the social and environmental risks

of production of unconventional gas – but it is important to note that no amount of rules

or regulations can reduce the impact of production to zero (World Energy Outlook,

IEA, 2012).

The industry is further constrained by geological and geographical realities. In

the United States this means that state laws play a key role in development, and that

more localized reactions to the practices of industry are influential in shaping policy.

Proponents of renewable energies point to environmental issues with fracking and

natural gas production, including methane leakage (and flaring), waste-water

mishandling, seismic activity, and carbon emissions. Still, as a cleaner and more

26

efficient alternative to oil and coal, there are distinct advantages for natural gas use,

especially in electricity, transportation, and heating. Natural gas is not the long-term

fuel of the future, but it may be an essential step, a means of buying time for

advancements in other more efficient forms of energy. Whether or not this can be

carried out effectively remains to be seen.

A primary determinant of industry sustainability in market economies is the

ability of companies to secure financing. The grounds for financing in the

unconventional gas industry are tenuously based on the promise for future economic

viability. In the U.S. natural gas business as of 2010, major investors in North American

shale gas, such as Kepis & Pobe (over 12 billion USD market capitalization in

extractive industries) claim that global trends in natural gas and shale support the idea

that “gas is not only a ‘bridge’ but truly a ‘destination’ fuel in a lower carbon world”

(Kepis & Pobe, Report, 2014). The firm’s report titled “Natural Gas to 2030” was

prepared for potential investors and cites figures from the EIA and BP Statistical

Review demonstrating that growth in global unconventional gas to 2030 will increase

by 220%, making it especially attractive for institutional investors. These numbers have

increased even more in recent reports. Nonetheless, it is clear that much of the firm’s

optimism hinges on the continued economic viability of shale production, while also

relying heavily on figures for ‘technically recoverable’ rather than those that are

‘proven.’ The productivity of shale plays has been decreasing even as more wells are

being drilled. A report from the Oxford Institute of Energy Studies demonstrates that

despite capital investment in the Bakken, there is a limited return to average well

production.9. Though the capabilities of businesses vary, there is a threshold at which

production becomes too expensive to be viable; especially as low gas and liquids prices

due to production growth reduces revenues (Sandrea, 2014). For natural gas depletion,

9 See Appendix B: Figure 5. Average production (b/d) in Bakken (2013)

27

and resource distribution, particularly telling are the rates at which consumption

outpaces production, as illustrated in gas-reserves-to production (R/P) ratios by year

(BP Statistical Review, 2014). The figure demonstrates the fragmentation of global gas

reserves, with a disproportionate reserve-to-production capacity, upwards of 150 years,

in the Middle East.10 Ultimately the economic value of investments in natural gas by

firms is predicated on speculation on future growth, and the forces of government

policy, but no policy can increase domestic natural resource realities.

4.3 The Role of Government

The idea that government should support and foster institutions of industry,

rather than seek to control them is indicative of the evolving role of the state in natural

gas markets as discussed in Mark Hayes and David G. Victor’s chapter in the book

‘Natural Gas and Geopolitics.’ Hayes and Victor imagine an ‘old world’ and a ‘new

world’ of gas trade, a division that plays a part in preventing a truly global marketplace.

The ‘new world’ idea embodies a shift to more market based, and less state dominated

economies. Where states still dominate production and arrange trade at the inter-state

level the ‘old world’ is more predominant (Hayes & Victor, 2005). Foss offers that the

US embodies the perfect case study for a state in a transitional phase, where regulations

are used to address the challenges of young competitive markets (Foss, 2005, 116). The

role of the state in the case of the United States has been increasingly to be the

“provider of market institutions that create the context for private firms to take risks and

reap rewards from investment in costly gas infrastructure projects” (Hayes & Victor,

2005, 10). The shift to market organization reduces the burden on the state, and

incentivizes investment and competition. The study ultimately finds that risk still

abounds and is largely a factor of government energy policy, even despite the 10 See Appendix B: Figure 6. Historical global reserves-to-production (R/P) ratios for NG in trillion cubic meters (tcm) per year

28

availability of financing for infrastructure projects that are slow to realize returns. In

short, the marketization of natural gas has been part of larger economic liberalization

policies, demonstrating the power of competitive markets and pricing.

Government must also consider how to levy corporate taxes and royalties

efficiently to regulate the industry. The optimal method of royalty design for extractive

industries is in the collection of economic rents. Royalties vary primarily because of the

uneven geographic distribution of supply, and pre-existing state legislature. Rent based

royalties are uncommon in the United States, in part because of the already high

corporate income taxes. Corporate taxes on income and investment can also help to

regulate investment and production. Stimulus in investment can lead the development of

new technologies, but ultimately it is business that decides whether or not to pursue new

development opportunities (Weijermars, 2010). The primary source of government

revenue from gas is from corporate income tax rates in the US, and at a net corporate

tax rate of 40% in 2014 the rate was among the highest in the world (Corporate Tax

Rate Tables, KPMG). For Colorado, severance taxes are at a reduced rate but gradually

increasing, to an eventually fixed rate for shale production, in order to encourage

production. A 2012 research paper from the University of Calgary’s School of Public

Policy examines “Capturing Economic Rents from Resources through Royalties and

Taxes” outlining the important relationship between government and business. In

Pennsylvania as of 2012, no royalties or severance tax existed for extractive industries

(Mintz & Chin, 2012). Squeeze business too hard and they’ll reduce output and

government revenues will be lost, give too much leeway and important government

revenues will be lost. At either end of the spectrum, energy security from a

governmental standpoint is at risk. A contract between industry and the public is neither

efficient nor sufficient in ensuring energy security of supply; government involvement

is essential.

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4.4 Regulating Natural Gas

Natural gas is a publicly traded commodity in the U.S., and as a result has

private and public features. The fuel accounts for nearly a quarter of U.S. domestic

energy consumption, so the industry is necessarily subject to regulation (BP Statistical

Review of World Energy, 2014). The asymmetrical, often remote, distribution of

natural gas reservoirs means that regulations must be especially tactile. The challenges

for effective legislation of extractive industries are both physical and political in nature.

Federal regulations must consider environmental impact, industry sustainability

(financially and materially), international trade and distribution, and ultimately how best

to allocate the benefits of production throughout society. Production and trade of shale

gas and other unconventional NG sources present particular challenges, as well as

opportunities for regulatory policy. The United States has demonstrated how

governmental agencies, and courts can build incrementally upon pre-existing regulation

to improve practices and efficiency (IEA, World Economic Outlook, 2012). The

emergence of more competitive upstream, midstream, and downstream businesses, vis-

à-vis trading hubs, and transit improvements in pipeline and LNG market integration in

the U.S. are a direct result of liquidity in the market that has been fostered by both state

and federal regulations (Weijermars, 2010, 92). A competitive market breeds domestic

market unification and is beneficial to regulators, as it allows for broader and more

effective regulation, thus furthering energy security of supply goals. Additionally, the

synchronization of local and global markets creates opportunities and cost reductions

for energy consumers from the wholesale down to the household level. This section will

examine the extent to which investment growth and developmental opportunities in the

gas value chain in North American unconventional gas production have been cultivated

by government.

30

Because natural gas is a finite resource, the average production cost in the long

run increases as more costly plays are pursued to meet demand growth. It is easy to see

how legislation aimed at limiting the depletion of natural gas reserves, by introducing

efficiency standards, and restricting development of high cost unconventional plays,

would help to lower prices, but it is difficult to conceive of such controls having net

positive outcomes. For one, external pressures to domestic production, such as import

supply insecurity may drive up demand and increase prices; this can lead to lower

demand and may discourage further investment in infrastructure and development

(Dale, 2006). Even before fracking was introduced for natural gas, Foss (2005)

proposed the need for the “incorporation of best practices to manage to mitigate soft

issues [read environmental and political] in order to protect and maximize, benefits

from energy investment, especially for affected local host communities” (Foss, 2005,

120, inserted). Indeed the scope of energy regulatory policy, as has been put forward, is

distinctly local. It is primarily for this reason that state regulation has won out over

federal in fracking. Foss recognizes that standardization, or regulating business

practices with sweeping policy, is a “popular concept but one that also is very

complicated in reality” (Foss, 2005, 124). The boundaries to standardization are indeed

in the divergence of cost of production based on resources available and efficiency of

production methods.

The role of regulation is in part to dilute the impact of supply and demand

shocks, and to reduce the negative externalities of production on the economy. Supply

gluts can lead producers to scale back demand in an effort to raise prices, and therefore

profit. However, this can lead to insufficient storage of fuels for peak-usage periods. In

the United States, demand in the form of end user consumption volumes is directly

impacted by the severity of winter temperatures, because gas is predominantly used in

heating, though increasingly in electricity generation. Under growing market

31

liberalization, commodity price risk is divided between consumers, retailers, producers

and government (Foss, 2005). Yet, only so much can be done domestically to reduce

risk in the face of international and unpredictable factors. Regulations cannot hope to

account for all exogenous factors affecting consumption trends domestically, because

the business operations that produce, process, transport, and retail gas are carried out by

thousands of different companies, and capabilities vary.

Regulations cannot be seen as economic austerity measures, but they can work

to make markets for gas more efficient. Regulatory policies have increased the

economic power, as well as the integration, of pricing hubs, which makes for a more

robust market. Natural gas wholesale prices are set at the Henry Hub price where the

highest level of centralized trading occurs in the spot and futures markets.11 This

convergence in price, and the use of derivative markets further helps to distribute risk.

Low natural gas prices, as a result of unconventional development have demonstrated

the positive externalities that the growth of the industry engenders. The Platts Special

report on implications for the natural gas value chain, from 2012 indicates that a supply

surplus of natural gas, and reduced natural gas prices, has encouraged investment in

coal-to-gas switching among electricity generators. Similarly lower energy prices have

allowed legislators to pursue environmental policy goals. Today coal is being phased

out by tighter regulatory control as part of new provisions for the EPA’s Clean Air Act

(1970), which places limits on carbon emissions from coal-fired plants and makes coal

less viable economically. The process of moving away from coal and towards natural

gas forces American coal to compete on the international market and therefore adapt, or

die, if CCS technology is not advanced (Kenderdine & Moniz, 390). In 2012 Wells

Fargo Securities analysts noted a median rate of 6 Bcf/d across the U.S., which was 6

11 See Appendix A: ‘Spot market’ and ‘Futures market’

32

times as great as the demand increases expected in 2020 for Ontario where coal

retirements are legally mandated (Platts, 2012).

4.5 Analysis of Regulatory Approaches

The United States Federal Energy Regulatory Commission (FERC) has had an

especially strong effect on the U.S. natural gas market. Regulations from FERC, the

court system, and U.S. Congress have helped to liberalize the market, but also played a

part in prolonging its infancy. Regulations on wellhead gas prices by the Federal Energy

Regulatory Commission (FERC) in the 1950’s were crippling to the industry even

before geopolitical events brought energy prices crashing in the 1970’s. In 1954 the

Phillips Decision, set a precedent of governmental control for the industry, by ensuring

that the then Federal Power Commission placed controls on wellhead prices and

stretched its jurisdiction to exploration and production regulation. These price controls

were initially positive in that they fostered low prices, stability, and growth. Following

the 1973 OPEC embargo, however, wellhead prices soared, and consumption declined.

Price volatility due to “stringent government price controls” was revealed and a

“complex process of deregulation” was undergone (Hefner, 2014, 13). In effect these

early controls led to the high ceiling prices of ‘take or pay’ contracts in the 1980’s, and

a bubble in bundled pipeline contracts for local distribution companies formed when

customers chose alternatives when oil prices dropped. Joskow’s 2013 study

demonstrates the need for flexible regulations to create lasting and robust natural gas

markets and infrastructure.

The Natural Gas Wellhead Decontrol Act of 1989 allowed for further

normalization of prices and reductions of shortages. It was only after this that the

market for gas “matured,” and with the development of spot and derivative markets,

trading hubs, etc. an atmosphere conducive to production was created. Favorable

circumstances and technological breakthroughs for E&P allowed for the shale

33

‘revolution’ to occur (Joskow, 2013). Furthermore it is made clear that contract terms,

and the dynamics between supplier, distributor and customer in tandem with

governmental controls are of unique importance to the natural gas industry because of

the vulnerability to geopolitical and international events vis-à-vis price variations in oil.

The Decontrol Act coupled with FERC orders 497 (1988) and 500 (1987) redistributed

costs to shippers and traders, reduced monopolization by pipeline companies, which

created more market competition in distribution. This unbundling reduces the burden on

retail consumers who absorb a significant portion of the value added costs that are

accumulated through the value chain (Foss, 2005). The implications of FERC orders

and state regulation can be seen throughout the development of both the physical and

financial natural gas value chains to increase E&P. As E&P becomes more profitable,

control on essential distribution services decline, primarily because of the inability of

states to regulate interstate pipelines without significantly increasing costs for local

consumers. FERC and state regulations, despite having enabled the shale revolution by

reducing costs for end consumers and increasing incentives for upstream production,

squeeze mid- to downstream practices which are essential to efficiently adding value to

nature gas production (Weijermars, 2010).

Furthermore, the lack of stringent control on upstream business is evident in the

absence of federal regulation in fracking for natural gas, which has allowed the

neoliberal economics of big businesses in extractive industries to thrive. The

implementation of fracking is present in more than 90% of new wells for oil and gas has

had mixed public reception in the United States (Warner & Shapiro, 2013). Fracking

has been freed from governmental controls by multiple exemptions, which may either

prove critical to industry growth and could possibly be detrimental to public trust and

environmental security. Congress has allowed for fracking’s exemption from multiple

EPA regulations including: Resource Conservation and Recovery Act (1976), the

34

Emergency Planning and Community Right to Know Act (1986), the Clean Water Act

(1948), and the Hazardous Materials Transportation Act, and more recently from the

Clean Air Act (1970). This sizable list of regulatory exemptions limits the government’s

role in monitoring wastewater from fracking, and it keeps secret the cocktail of

chemicals used in the fracking process. Regulation at the state level for upstream

operations is prohibitive to swiftly implementing best practices at the wellhead, where

the majority of environmental concerns take place.

Successful lobbying on behalf of Halliburton led to the modified definition of

“underground injection” in the Energy Policy Act of 2005 to exclude fracking fluids

(Warner & Shapiro, 2013). This demonstrates the elevated nature of energy policy in

government, and the importance of a successful energy industry for successful

economies. The close tie between government and industry is in part because of the

significant revenues from shale and taxes that can be levied from production, thus the

status quo of industry-based standards persists in most U.S. states. In terms of scientific

proof of harm done by fracking, the industry has essentially been operating on ‘innocent

until proven guilty’ terms. Only recently in December 2014, when New York State

banned fracking altogether due to health risks, has the lack of scientific proof been seen

as a reason to stop fracking indefinitely, rather than as a reason to continue potentially

harmful practices (Kaplan, 2014). Given the size of the Utica shale in New York, the

decision is significant for state and federal regulations, U.S. domestic supply reserve,

and the future of fracking practices.

Without significant controls on production practices, self-interest is allowed to

remain the norm. Energy supply concerns seem to frequently outweigh the worries over

the negative externalities of production at the Federal level in the United States. The

danger of environmental destruction, and displacing whole communities, presents

greater potential energy security risks for the state (and the country) than solely losses

35

in capital from revenues. The potential costs of limited federal regulation in increasing

negative externalities could outweigh the benefits of domestic supply, and undermine

energy security goals. Nevertheless, state policy has advantages to federal, because

public reaction is more salient in state legislature. This would be more effectively

discussed using empirical evidence, yet determining how to best measure this cost

benefit relationship though is problematic with little understanding of the full effects of

fracking at present and for the future.

36

5. Foreign Perspectives

Because of the energy industry’s reliance on fossil fuels, the U.S. and the global

community is extremely susceptible to the uncertainty and volatility caused by conflict

and political unrest in supplier countries. Internationally, the affairs of major players in

energy, such as Russia, the Middle East and North Africa (MENA), and China, must be

monitored because of interdependence for energy security in the global economy. To

illustrate the imbalance in supply reserves: approximately one third of the world’s oil

supply transport goes through the narrow Strait of Hormuz at the mouth of the Persian

Gulf in the MENA region (International Security Advisory Board, 2014). This has led

to a constant presence of U.S. Naval carrier ships in the region, and indicates the ties

between national security, global security and the security of energy supply. Additional

factors such as foreign regulatory settings, reserve potentials, foreign domestic politics

and industry capabilities all impact a nation’s energy policy considerations. However,

despite the difficulties in anticipating fluctuating economic circumstances

internationally, the U.S. government still faces the task of ensuring to its greatest ability

that citizens have cheap and reliable sources of energy.

Tapping unconventional resources globally could help satiate demand in

developing countries, but even as energy supply grows, the total supply available

declines. The lack of pre-existing infrastructure and diverse energy capabilities abroad

are just a few of the serious barriers to creating a more global industry.12 Investments by

private companies in shale gas infrastructure are more risky in countries that have not

developed the infrastructure to facilitate demand growth. For shale gas globally, as

British Petroleum’s (BP) Energy Outlook 2035 demonstrates, the majority of

technically recoverable reserves are located in Asia, and in particularly arid areas of

China, where the water needed to frack is scarce and the government controls energy

12 See Appendix A: ‘Unconventional Resources’

37

production and distribution (BP Energy Outlook 2035, 2014). That said it is

increasingly important to view energy from a regional perspective, because of the

regional nature of natural gas trade that reduces costs in getting supply from the

wellhead to the burner tip.13

Where increasing demand and scarcity once defined U.S. policy concerns, now

growing domestic production and abundance provide new opportunities for U.S. policy

(Verrastro and Book, 2013). Despite this the acknowledged abundance of U.S. domestic

gas supply should not skew policy judgments given that the United States only controls

a portion of global gas resources. Diversification domestically in the U.S. can be seen as

a positive transition towards advances in technological efficiency and greater potential

for international influence, but not as a panacea. Whereas in 2013 natural gas trade in

North America was primarily regional, the growing development of LNG capabilities,

and the approval of export terminals are expected to make the U.S. a net exporter of

LNG by 2015 (Azreki, 2014, 31).14 The practical development of a more robust LNG

trade market would allow LNG producers to equip supplies to countries in trade

agreements with the U.S. under duress from regionally dominant producers, thereby

strengthening U.S. economic influence (Shaffer, 2012).

In foreign policy, the increase in natural gas regional pipelines has demonstrated

the necessity in enacting economic sanctions to counteract the use of energy supply as a

weapon of statecraft by individual countries. Natural gas pipelines must cross multiple

state borders for export in some cases, and this can create situations where consumer

states are cut off from supply by conflict between producer and transit states over

pipeline rents (Shaffer, 2012, 5). Russia’s (supplier state) annexations of Crimea from

Ukraine (transit state) are a prime example of the use of energy as an economic and

13 See Appendix A: ‘Wellhead’ and ‘Burner tip’ 14 For a clearer view of the level of regional distribution in natural gas see Appendix B: Figure 7. Global Major Trade Movements of Natural Gas (bcm)

38

political weapon, in disrupting supply to Europe (consumer state). Sanctions against

Russia have allowed the U.S. to aid Europe in attempting to ensure supply security, but

Russia’s persistence in the Ukraine, and threats to turn off the pipeline, further indicate

the need for a robust LNG market, diversification and investment in renewable fuels.

U.S. supply increases are being viewed as a crucial transitional step towards

more efficient technologies, and cleaner energy (Kalicki and Goldwyn, 2013).

Nevertheless, until green technologies are price competitive, global dependence on

fossil fuels will persist. Barriers to a global market for gas exist due to the continued

dependence on oil pricing globally, and the ability of countries with highly centralized

internal production to leverage their supply. This dependence and centralization

prohibits competition on the global level, and gas markets are more regional as a result.

Global energy security challenges in respect to the U.S. hinge on the roles that major

energy suppliers take in the global marketplace. In the global gas network, state owned

companies, in the absence of competition, are able to monopolize production and

control the value chain upstream and downstream (Mintz & Chin, 2012). In China,

government control has led to gas prices in long-term contracts pegged to those of crude

oil, which proliferates the role of oil producers. Furthermore, the reality faced by China

of limited water supply in shale rich regions may lead to foolhardy governmental

production of shale by fracking that could displace entire communities.

State owned ventures often lack the financial resources to develop cost-effective

distribution networks in line and novel production methods. Additionally, in the

absence of private landowners, the value of economic rents is evaluated by the state,

which skews global expectations and provides further barriers to a global market. The

lack of competition, and the absence of a dynamic value chain limits the potential return

on production investments, and decreases the ability of experienced E&P companies to

introduce more efficient technologies and practices in unconventional plays. This is

39

endemic to restrictive land usage and mineral resource policies in countries such as

China and Russia where energy production is state managed, and economic potential

and development is therefore limited (Foss, 2005). The monopolization of resource

wealth by state-run business stunts efficiency in terms of capital return.

For OPEC countries, limits to new investments have led to fragmentation based

on resource wealth. Investments in new production have been limited by price and

competition from shale, and cheaper liquids (Jaffe and Morse, 2013). As a result,

individual OPEC member countries with greater reserves such as Saudi Arabia become

more important in global market pricing than the cartel itself. Indeed, OPEC member

Venezuela’s economic collapse, as a result of the inability of its state owned energy

business to diversify and invest in unconventional plays demonstrates the dangers of

inequities between state and business in managing energy security. Inefficient

production of world resources is just one further challenge to managing energy security.

40

6. Conclusions

No single overarching policy for energy security exists, because the goals for

security in terms of national political economy are so broadly realized as reliability and

affordability of energy supply. In reality, the requirements for energy security are

constantly in flux. The issues of sustainability, environmental impact, and limited

returns to capital investment, are rooted in in the modern economic system as described

in Chapter 2. There is no clear path to achieving energy security, but on a global scale

policy strategy more broadly needs “to create a more interdependent, stable, and

climate-friendly system” (Kalicki and Goldwyn, 2013, 548). This increasingly entails

creating flexible scenario based policy at the domestic level, and physically decreasing

dependence on single fuel sources through diversification. The unexpected abundance

and production of shale gas has proven essential and timely towards these goals.

Nevertheless, the ability of policymakers to navigate the energy system is difficult

given its vast reaching expanses and diversity.

The primary focus of this dissertation was to demonstrate the relationship

between energy security, and shale gas in the U.S., given developments in technology

and reserve potential. This has further led to a distinct focus on domestic developments

with insight into the possibilities that can be created for policy through technological

change and proper management of industry. It is clear that monitoring self-interest in

government and in industry is important to reduce inequity within essential value chain

operations. The role of the United States government in developing its domestic shale

gas potential and efficiently extracting value therefrom has proven pivotal thus far in

increasing domestic supply security, and increasing the potential for influence abroad

given reduced dependence. Its broader success in terms of energy security is better

judged in the long-term, because of the unknown effects of negative externalities of

41

fracking. A reliance on industry knowledge in policy further points to the need for a

balance between industry-based policy, and wider energy security goals. More can be

done by Congress to support research and development to attempt to implement the

more efficient wellhead practices that are present in big E&P business in smaller

businesses that are more likely to cut costs. There will always be a level of

environmental energy security concerns, so long as exhaustible fossil fuels are the main

sources of energy and by extension economic growth. Whether or not further increases

in efficiency and technology can help meet rising global demand remains to be seen.

This research has just scratched the surface in attempting to grapple with the

issues of energy security, and shale gas alike. Developments occur daily, and effect

relationship dynamics between industries and states. The most recent price shock to oil,

unexpected by those in the industry and in policy, demonstrates the continued level of

unpredictability that is so difficult to manage. A more in-depth examination of the link

between oil and gas pricing dynamics would be an imperative next step in

understanding policy considerations. This would require extensive empirical work, and

would have to draw on a more in depth understanding of both the oil and gas industries.

Furthermore, an examination of the diverse policies that are being undertaken

domestically and in foreign politics to reduce the negative externalities of fossil fuel use

would also provide a valuable dimension to this study. Further study could carry out

similar structured analysis on the role of foreign governments in developing shale gas.

The literature on regulatory regimes in relation to unconventional production globally is

sparse, but a comparison of the U.S. with other regulatory regimes would compound the

unique nature of U.S. extractive policies, but would ultimately underline the common

reality that policy is subject to unpredictability and the inevitable depletion of

exhaustible resources.

42

Appendix A: Industry Terms

Burner t ip Phrase used to describe the end point of consumption for natural gas

Derivative market A marketplace established for distributing the burden of price risk in energy industries in the form of futures, and contracts Downstream The refining and distribution operations of petroleum or gas products Futures market A marketplace in which prices and quantities of specific commodities are fixed for exchange in the future Horizontal Dril l ing Novel form of drilling used primarily in shale deposits that enables multiple extraction points from a single wellbore rather than from many vertical wells Hydraulic Fracturing (Fracking) Form of stimulating well flow by injecting pressurized fluid, a combination of chemicals, sand and water, into the wellbore to fracture source rock Midstream The business operations of pipeline, truck, and other transportation methods from the wellhead to downstream processes Spot market The market in which prices of a commodity are settled in cash for immediate distribution Unconventional Resources For natural gas, these include shale gas, as well as tight gas, and coal bed methane. In North America, shale gas is found most notably in the Marcellus, Bakken, Eagle Ford, Utica, and Barnett shale formations Upstream The business operations of E&P of gas and oil products Wellhead The physical pressurized components in place at the wellbore for drilling and producing resources

43

Appendix B: Graphical Representation

Figure 1. “U.S. primary energy consumption by fuel, 1980-2040 (quadril l ion Btu)”

(EIA AEO 2014)

Figure 2. “U.S petroleum and other l iquid fuels supply, 1970-2040 (mil l ion barrels per day)”

(EIA AEO, 2014)

44

Figure 3. Natural Gas Physical Value Chain

(Weijermars, 2010, 88)

Figure 4. “Electrici ty generation from natural gas and coal, 2005-2040 (bil l ion kilowatt -hours)”

(EIA AEO, 2014)

45

Figure 5. Average shale gas production (b/d) in Bakken (2013)

(Sandrea, 2014, 8)

Figure 6. Historical global reserves-to-production (R/P) rat ios

for natural gas in tr i l l ion cubic meters ( tcm) per year

(BP Statistical Review, 2014)

46

Figure 7. Global Major Trade Movements of Natural Gas (bcm)

(BP Statistical Review, 2014)

47

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