U.S. Advises Oil Companies How to Break The Law, Approves LNG Despite Fracking Fallacy Debate

In the waning hours of 2014, the U.S. government slipped a few things past us:

• It advised oil companies how to get around the law prohibiting crude oil export by "self-classifying" crude oil as "not crude oil", and 
• Approved an LNG export facility despite the Fracking Fallacy debate that suggests that the U.S. may not have enough natural gas to meet our own demand in a few years much less send gas to the rest of the world.

On December 30, 2014, Reuters reported that the U.S. Commerce Department's Bureau of Industry and Security advised oil companies that they could self-classify their light tight oil and condensate as "processed condensate" and legally evade the ban on exporting crude oil.  Crude oil export has been illegal since 1975 when President Ford signed the Energy Policy and Conservation Act (EPCA). The idea behind the legislation was to keep domestic oil in the U.S. as a strategic buffer against the global oil price fluctuations created by the embargoes of 1967 and 1973.

I do not support the ban on exporting crude oil but it is the law.  Congress should debate the law and vote whether to keep or repeal the law. The Department of Commerce has given the oil companies a "wink" letting them know it would be OK to export their light oil if they just call it something else. Isn't it is illegal to advise people how to get away with breaking the law?

Oil companies have been calling for reversal of the EPCA since early in 2014 arguing that surging U.S. production from shale has fundamentally changed the conditions that lead to the ban on exporting crude oil.  When the EPCA was signed, the U.S. was producing 8.3 million barrels of oil per day (Mmbopd) and production was falling.  Today, production is 9.0 Mmbopd and increasing.

The real issue, however, is that most U.S. refineries are not designed to process the light tight oil produced from the Bakken and Eagle Ford shale plays.  It has a lower specific gravity than ordinary crude oil (WTI--West Texas Intermediate is the standard for the U.S.) and must be blended with heavier oil from Canada, Mexico or Venezuela so it can be refined into diesel, gasoline, jet fuel and other products which may be legally exported.

This, by the way, is the real reason for the Keystone XL pipeline from Canada. It would bring super-heavy crude oil from the tar sands in Alberta that would be perfect for blending with light tight oil.  President Obama is right when he says that little of this Canadian oil would be used in the U.S.  He is dead wrong, however, when he says it would not benefit the U.S. because it would increase refining jobs and U.S. exports, and lower U.S. gasoline prices--all good for the economy.  

Diesel is the cash cow among refined products because it is in high demand in overseas markets.  Gasoline is a more-or-less unwanted by-product of producing diesel and that is why the price of gasoline has been going down in the U.S. since the rise of light tight oil production.  A surplus of gasoline forces its price down.

So, the ban on crude oil exports is good for American consumers because it maintains and creates refining jobs, helps with our balance of trade and lowers the cost of gasoline.  Allowing oil exports would streamline the process for oil companies since they would not have to bother with the refining step but would mean that most of the refining of U.S. light oil would be overseas which would not be as good for the U.S. consumer.

If President Obama is against the Keystone XL pipeline, it makes sense that he is for exporting crude oil but he won't say that because that would put him in the same camp as the oil companies.  He has, therefore, cast the Keystone XL as an environmental issue saying that the U.S. should not promote the "dirty" process of tar sand mining and extraction in Canada.  I'm going to stay out of that discussion but I doubt the Canadians are going to abandon the tar sands because their neighbor does not approve a pipeline.

Obama clearly favors taking a regulatory approach to complex problems instead of the more cumbersome process of passing or repealing laws.  It is wrong to offer oil companies a regulatory solution that borders on illegality when it would be right to debate the Energy Policy and Conservation Act and reach a clear course of action.

Also in the last minutes of 2014, FERC (Federal Energy Regulatory Commission) approved Cheniere Energy's request to build its Corpus Christi LNG (liquefied natural gas) Terminal in southern Texas.  Other LNG export facilities were previously approved but this is the first green-field facility to be authorized.  Its cost will be approximately $12 billion.

The timing of this approval is wrong because of the Fracking Fallacy debate that casts doubt on future supply of natural gas in the United States.  The government should postpone decisions on new export licenses until the present debate on supply is resolved or at least better defined than it is today.

Ironically, Oklahoma billionaire George Kaiser's company Excelerate Energy announced that it will postpone its floating LNG terminal planned near Cheniere's Corpus Christi project.  The main reason appears to be questionable economics now that oil prices have fallen--most overseas LNG contracts are linked to oil prices. The difference between Excelerate's decision and Cheniere's decision seems to be about George Kaiser spending his own money versus Cheniere spending other people's money.

I do not support banning LNG export although I think it is a profoundly bad idea based on economics and likely higher natural gas prices in the U.S. once shale gas supply peaks near the end of this decade.  It is inappropriate, however, for the government to move forward with approvals while the Fracking Fallacy debate about future gas supply is high on the national energy agenda.

David Hughes Weighs In on The Fracking Fallacy Debate

In the current debate about the Nature article "The Fracking Fallacy," the discussion has focused on estimates of cumulative production of shale gas plays by the Energy Information Administration (EIA) and The Bureau of Economic Geology at the University of Texas (UT/BEG). 

David Hughes provides another estimate in his recent post "Fracking Fracas: The Trouble with Optimistic Shale Gas Projections by the U.S. Department of Energy," a summary of his comprehensive study of all U.S. shale plays Drilling Deeper published by The Post Carbon Institute.

The Fracking Fallacy debate is important because it casts doubt on the reliability of government estimates of our natural gas supply.  If U.S. gas production is in decline by the early 2020s as described in the Nature article, or sooner as I suspect, then important policy decisions about the export of natural gas and the retirement of coal-fired electric power plants have been based on questionable information. 

Cumulative production estimates are interesting but do not address the economics of shale plays.  Proven reserves provide a more meaningful estimate because they supposedly represent volumes of oil and gas that can be produced commercially at a particular price.  

There are two categories of proven reserves:  proven developed producing (PDP) and proven undeveloped (PUD) reserves.  PDP reserves refer to volumes of oil and gas that have been proven by drilling a well, testing its production and projecting its estimated ultimate production (EUR). PUD reserves are those volumes of oil and gas that can be inferred to be commercial but have not yet been drilled and tested.  PUD reserves are booked based on proximity to PDP reserves.  

Considerable uncertainty exists about the commerciality of shale production because of the lack of long-term production history to validate the EUR.  I doubt that much of PDP shale gas reserves are, in fact, commercial based on our economic analysis of the Marcellus, Haynesville, Barnett and Fayetteville shale plays.  PUD reserves are even more questionable since they have not been tested by a well. These observations are confirmed by public filings of financial data to the Securities and Exhange Commission by companies involved in these plays.  This data shows that most companies have negative free cash flow and have extremely high debt loads.  In other words, they are losing money.

Proven reserves are, nevertheless, the best publicly-available measure of production potential from shale gas plays.  The nearby chart and table compare the ultimate production estimates by the EIA, UT/BEG and Drilling Down (DD) with 2013 proven and proven undeveloped reserves published recently by the EIA.

(Click The Figure To Enlarge)

(Click The Figure To Enlarge)

This data shows that both Drilling Down and UT/BEG cumulative production estimates are reasonably close to 2013 PDP reserves + PTD (Production To Date) + PUD reserves.  The UT/BEG estimate is nearly identical with the PDP-PTD-PUD estimate except that Haynesville Shale production appears to be over-estimated.  Drilling Down estimates appear to slightly under-estimate Barnett production and over-estimate Marcellus production compared to proven reserves.

The important take-away, of course, is that EIA appears to have over-estimated production for all of the plays by more than one-third (123 Tcf more) compared with total proven reserves.  Its estimate for the Haynesville Shale play is more than three times as high (70 Tcf more) as proven reserves.  EIA estimates for Barnett and Fayetteville are reasonably close to the PDP-PTD-PUD estimate. One has to wonder whether the people who do these production estimates for the EIA talk to the people in their own organization who do the reserve accounting.

The implication is that government estimates of shale gas supply appear to be highly optimistic compared with two studies by credible sources who I believe have done a much more thorough job than EIA of analyzing the production data by evaluating every individual well in the plays.  All three estimates are probably optimistic because they use EIA price forecasts that I believe are too low. 

How the SEC justifies approving reserves that financial data from the companies involved shows is non-commercial is a fascinating subject for another inquiry.  

The shale gas success story of multi-decade abundance is at odds with the findings of the Bureau of Economic Geology and David Hughes' work with The Post-Carbon Institute. The story stresses success based on resource estimates but not reserves, production volumes but not the cost of that production, the benefits of technology but not its price, and claims of profit that exclude important expenses.  

The government and press accept this story because it paints a picture that fulfills so many aspirations of energy independence, U.S. re-emerging political strength, dominance in energy affairs and economic growth that warning signs of potential risk have so far been ignored.  

Shale gas has provided the United States with a decade of supply that was not recognized as recently as 2005.  That is a good thing.  However, it probably represents a hiatus in the decline of U.S. gas reserves rather than a fundamental change in energy supply.

Why The Debate Over The Fracking Fallacy Is A Big Deal

The debate about “The Fracking Fallacy” is a big deal because EPA’s* plan to regulate coal out of existence is based on EIA’s* forecast of abundant and cheap shale gas for decades.   If U.S. natural gas production is in decline by the early 2020s as described in the Nature article, there won’t be enough electric power supply without more, rather than less, coal. And power will cost more. In addition, DOE’s* approvals for natural gas export to Asia, Europe and Mexico may now become truly awful and misinformed decisions.

The magazine Nature published “Natural gas: The fracking fallacy” on December 3, 2014.  The article’s author Mason Inman described how the expectation of decades of abundant natural gas in the United States might be wishful thinking. He compared the Bureau of Economic Geology (BEG) and EIA gas supply forecasts in the nearby figure.   The BEG forecast has U.S. gas production peaking in about 2020 and then, declining sharply.  The EIA prediction is for gas supply to continue increasing into the mid-2020s and then, to remain strong into the 2030s.

Source:  Bureau of Economic Geology (click the figure to enlarge)

Both the EIA and BEG wrote letters to Nature last week stating that Inman’s article was misleading and biased.  More importantly, both letters emphasized that there really isn’t any disagreement between the two forecasts but that there are many differing scenarios that each group has developed because of the many variables and uncertainties involved with supply forecasting.

The Nature article has succeeded in casting doubt for the first time on the beautiful dream that fracking shale reservoirs can restore youth to an ageing American energy industry.  For years, a few industry insiders like me have urged caution about the jubilant projections for U.S. shale gas abundance coming out of EIA, the research departments of investment banks, and industry consultancies.  Things that sound too good to be true often are.

Why did the EIA and BEG jump into the fray when they might have chosen to say nothing and assume that this too would pass as, for instance, the New York Times “Drilling Down” series did in 2011? 

First, because the BEG is recognized as a major force in institutional and academic research with close ties to the oil and gas industry.  The BEG evaluated the performance of every individual well in all of the major U.S. shale gas plays.  Their work is the authoritative standard in my view.

And second, because of timing:  EPA air quality regulations go into effect in April 2015 that will greatly reduce the role of coal in electric power generation as shown in the nearby figure.  Resulting retirement of more than 60 coal-fired plants in 2015 would increase demand for natural gas as the substitute fuel.  Coal plant retirements will continue though 2025 and have been ongoing for several years already in anticipation of the new regulations. 

Source:  GAO (click the figure to enlarge)

EIA’s gas supply and price forecast formed the technical basis that justified EPA’s regulations that did not require congressional approval.  If BEG’s forecast is correct, U.S. gas supply will have peaked before the last coal plants are retired and after the majority have been shuttered.  What will the U.S. do for electric power if gas production is in serious decline?  The only options are to revert to more coal, quickly build nuclear power plants or somehow greatly accelerate development of wind and solar installations (but what to do about the necessary natural gas backup generators?).

Moreover, EPA regulations have relied on EIA gas price projections to further justify coal plant retirements.  These price forecasts say that gas will continue to be inexpensive for decades because of the abundant supply.  If that supply begins to decline, the price will increase meaning higher costs for U.S. homes and businesses.

To make matters worse, DOE has already given approval for natural gas exports by pipeline to Mexico and in the form of liquefied natural gas (LNG) to Asia and Europe.  

Source:  SENER and EIA  (click the figure to enlarge)

These contracts were also approved based on EIA supply and price projections.  Many industry advocates have stridently opposed these approvals arguing that gas export will increase their costs and diminish competitive advantage over foreign manufacturers.

Add it all up and it’s potentially a huge mess.  Interestingly, EIA Administrator Adam Sieminski did not sign the EIA letter to Nature.  We can only speculate why.

*EPA:  United States Environmental Protection Agency

*EIA:  Energy Information Administration, part of the U.S. Department of Energy.

*DOE:  United States Department of Energy