QuickTake on Fracking

With Lancashire based Cuadrilla Resources recently carrying out the first commercial extraction of shale gas in the UK since 2011, long standing investors have been strengthened in their resolve to replicate the success of fracking in the US on domestic shores.

Fracking refers to the hydraulic fracturing of shale rock to release oil and gas stored in the pore spaces of subsurface rocks. With the UK’s North Sea oil industry having seen its peak output achieved in the late 1990s at 2.6m barrels per day, and the subsequent two decade long trend of declining output set to continue through 2020, fracking technology has provided hope for investors of a new source of growth in the UK energy market.

Following a temporary ban on commercial fracking after the practice was linked to seismic tremors in 2011, Cuadrilla has now begun releasing gas trapped at a depth of 2.7km along an 800m tunnel near Blackpool. With 80% of UK households using natural gas to heat their homes, Cuadrill argues that its fracking venture in Lancashire could help reduce the UK’s reliance on imported energy, and the CO2 emissions associated with the importing of Liquified Natural Gas. The Preston New Road shale gas exploration operations of the firm has already seen Cuadrilla invest £10m in Lancashire’s economy.

In the USA, fracking to release oil trapped in shale rocks has expanded rapidly over the past decade, with firms committing significant capital expenditure to opening hundreds of new onshore oil rigs. This has led to a production boom, with output in excess of 8m barrels per day in January 2018. Many US firms have, however, struggled to make this practice profitable, with exploration largely financed through the issuing of $293bn worth of bonds between 2008-17. The share prices of these firms have been held back by persistent concerns about the significant cash outflows as a result of capital expenditure, and the potential for a rapid increase in US oil supply to fuel a global oil glut, driving down prices and undermining the profitability of US firms.

Despite this, productivity gains have meant that some firms are now driving down production costs, allowing them to break even or achieve profits at lower global oil prices. US firm Pioneer Resources has seen a 300% increase in productivity over the past 4 years and is now able to break even at oil prices of less than $25/barrel, down from $55-60/barrel in 2014. A combination of lower costs and rallying oil prices means the US fracking industry as a whole may reach its break-even point by the end of 2018.

UK fracking companies face further challenges in addition to those of their US counterparts. The UK is much more densely populated, making securing permission to open fracking wells more difficult due to the potential for extraction activities to impact on local populations. There are continued concerns in Lancashire about the potential for fracking to trigger minor earthquakes, with a 1.1 magnitude tremor in late October leading Cuadrilla to pause fracking activity for 18 hours. In the UK, strict regulations mean that any tremor of 0.5 magnitude or above as a result of fracking is classified as a ‘red’ event by the Oil and Gas Authority, meaning fracking must be paused while tests are carried out. In Europe, the equivalent regulatory figure is a 2.5 magnitude event, and this is higher still in Canada at 4.0. Such stringent UK regulations as well as the continued vocal opposition of protest groups such as ‘Frack-Off’ and Greenpeace represent major challenges to the industry in the UK.

Shareholders in AJ Lucas, the Australian parent company of Cuadrilla, have seen considerable share price volatility as a result of developments in the UK shale industry. The granting of a permit by the UK government allowing Cuadrilla to resume drilling led to a jump in the share price to 60 cents on the 4th of October, but the subsequent halting of extraction following tremors saw the price collapse to 38 cents.

The difficulties faced by US firms in a more geographically favourable location and more relaxed regulatory environment coupled with continued local opposition and the significant capital expenditure required by the industry means that the UK fracking industry is faced with an uncertain future. Although the government appears keen to support the expansion of a new energy industry in the UK, shareholders are likely to be faced with considerable risk and volatility in the coming years as firms attempt to generate their first profits.