How Important is Shale Gas to the Energy Markets

Shale gas is being widely tapped in the U.S., but whether and to what extent other countries,―particularly in Europe and China,― will adopt it remains unclear. Although estimates vary as to how much of this unconventional and controversial fuel is bound up in domestic shale formations, natural-gas prices are likely to remain low for the time being. In this interview, Harvard Business School (HBS) professors Rawi Abdelal and Forest Reinhardt discuss the implications of shale-gas fracturing (fracking) for the global energy landscape.

Q. How important is shale gas to the domestic and international energy markets?

Abdelal: We do not yet have reliable estimates for the proven reserves of shale gas in the United States, but it does look like it could last a while, and so its price impact on U.S. competitiveness is likely to be very large. Shale gas will also affect other sectors of the U.S. energy industry. Burning coal to create energy when natural gas is plentiful and cheap suggests that we’ll be focused more on gas-fired energy production than on coal-fired energy production for the near to intermediate term.

The bigger question is whether there is enough unconventional gas in the U.S. to make it a major exporter of liquefied natural gas (LNG). If we have as much as we think we have, and if we allow exports of LNG, then that has the potential to really transform the entire global energy landscape.

Reinhardt: American gas prices have fallen by a factor of three or four over the past few years. Cheaper gas is changing the relative prices of different energy technologies. It’s changing the input costs for energy-intensive industries, and it potentially could affect the transportation sector, which would be even more significant. If a bigger fraction of the fleet can run on gas-based rather than oil-based fuels, the effects on world energy markets will be profound.

The stakes are huge. The market’s willingness to pay for energy services vastly exceeds the costs of producing the commodities. An enormous amount of economic surplus is up for grabs. This is why the energy business has been so interesting to businesspeople, and why it’s been so interesting to politicians. Yes, companies are making a very handsome living on a relatively small fraction of the economic surplus, but the rest is going to benefit the consumer.

Abdelal: Shale gas is important for a handful of nations where individuals rely more on exports of gas for income, and governments rely on them for revenues. It has huge implications for Russia, for example. Russia has its own unconventional gas resources, but it’s not likely economical to develop them before exploiting its more conventional gas supplies. It has more conventional gas, by a wide margin, than any other country.

By convention, Russia’s piped-gas industry has been based on contracts that are long term and that link natural-gas prices to the price of fuel oil with some coefficients and after some time lag. Western European consumers have been paying higher prices that are tied to the price of fuel oil, and that have long-term contracts with take-or-pay clauses. Even if they don’t use all the gas, they still have to buy it. That’s been tough to swallow for France, Italy, and Germany during the worldwide economic slump.

Russia is under pressure to reconsider this conventional link between fuel-oil and gas prices. Will this delinking of oil and piped gas come to pass? I think that process is probably unavoidable in the long term, though unlikely in the medium term, and when it comes, it will represent a profound geopolitical shift.

Q. How does one reconcile the benefits of cheap and plentiful natural gas with the social and environmental costs related to extracting it?

Reinhardt: In shale gas, there are private costs having to do with the machinery required to drill the well, the chemicals required to do the hydraulic fracking, the energy costs of the fracking itself, and so on. In addition, there are some social costs, currently not systematically made private, which have to do with potential groundwater contamination.

When considering whether some energy technology makes sense, we’re implicitly balancing that total cost package with the benefits of having the energy as well as weighing the alternatives. And the way to reconcile these benefits and costs is through market mechanisms delivered through a well-regulated environment, with stable property rights and predictable regulatory consequences.

The environmental consequences of fracking do not in themselves constitute an argument not to frack. They should alert gas producers to make sure that the environmental burdens are not unduly large, and are not concentrated on people who do not have the wherewithal to manage them.

Q. Is it possible that the U.S. could become a net energy exporter by tapping its shale-gas reserves? Could such a development potentially impact the global balance of power?

Reinhardt: The U.S. is now a coal exporter, and presently imports some natural gas. As American gas production increases, we can liquefy the gas and put it on ships. The U.S. could sell it around the world. I think that will happen. I don’t think we’ll become an oil exporter, although the technologies for extracting gas from shale formations are also useful for extracting oil.

So shale gas could be a game changer. But it hinges on the transportation question: Will the U.S. create the infrastructure to run its vehicle fleet on electricity, or on compressed or liquefied natural gas? There are stiff coordination costs in this effort. Who’s going to build natural-gas vehicles if there’s no natural-gas-refueling infrastructure? And who’s going to build the infrastructure if there’s no fleet? Here are two sets of companies that historically have not cooperated with each other, the energy firms and the automakers.

The core problem, of course, is that oil and gas are imperfect substitutes for each other in the most important application, which is transportation. The big thing over the next few decades is that these two energy delivery systems are going to converge, either with gasification or electrification of the fleet or from the creation of liquid fuels from gas and coal, and that’s what’s going to disintermediate oil companies and oil producers.

Abdelal: With just a handful of exceptions, consumers can’t switch from oil to gas. But if gas prices remain low, that creates lots of incentives to produce technologies that make them more substitutable.

At the moment there’s not a big impact, so oil prices and gas prices are going to bounce around somewhat independently of each other on spot markets in the U.S. Going back to our Russia example, oil prices fluctuate due to market forces, and piped gas has been artificially tied to those movements. Eventually that linkage will break. When technological advances and concerted institutional effort make oil molecules and gas molecules actual substitutes, the more likely their prices will become very closely correlated.

Rawi Abdelal is the Joseph C. Wilson Professor of Business Administration and a faculty associate of Harvard’s Weatherhead Center for International Affairs. He is a member of the Business, Government and the International Economy Unit; a member of the executive committee of the Davis Center for Russian and Eurasian Studies; and a faculty cochair of the Global Energy Seminar.

Forest l. Reinhardt is the John D. Black Professor of Business Administration and a faculty cochair of the Global Energy Seminar.

Article appearing courtesy 3BL Media.