How Fracking Plunged Natural Gas Prices

September 4th, 2013

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This blog post was originally published on the blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

Fracking: This new technique to extract oil and gas is having a profound effect on the North American economy. But what exactly is it?

Today, natural gas is dirt cheap.

Take a look at this chart. 10 years ago, natural gas was trading around $5/mmbtu. It went all the way up to $$13 in 2008, but today, it sits at around $3.5. That's about 30% lower than what it was 10 years ago, and a whopping 70% lower than it was 5 years ago.

What gives? Fracking, that's what.

In this post, I'll explain how fracking works, and how that led to a natural gas boom that decimated its prices.

Basic Geology

No one knows for sure how oil and gas came to exist, but what I'm about to say is the accepted explanation.

Millions of years ago, many living organisms thrived on the earth. Those organisms died, and their remains started to accumulate. Due to the tectonic shifts and various other influences, those organic matter got buried under rocks and dirt.

This process kept happening. As more and more dirt and rocks piled on top of the organic remains, the remains kept travelling towards the center of the earth, at a very very slow speed.

It's warmer towards the center of the earth, and the pressure is higher. The organic compounds came unglued at these deeper depths, forming what we know as oil and gas. The rock in which the oil and gas formed is called 'source rock'.

As the organic matter transitioned to oil and gas, they became lighter in weight. Some of the oil and gas travelled upwards through cracks in the rocks, but most of it stayed in the source rock.

Some of the traveling oil and gas may have encountered rocks with lots of cracks on the way, through which they can easily travel. This is called the 'reservoir', for reasons we'll see later.

The oil and and gas travels up until it can't anymore, when they hit a rock with no cracks. This rock with no cracks is called the 'cap' rock. The oil and gas pools up just beneath the cap rock inside the reservoir rock, which is why it has its name.

This link has a nice picture that illustrates the various rocks.

The Traditional Way To Produce Oil And Gas

For over a century now, people have produced oil and gas by drilling through the cap rock to access the reservoir. They drilled up to a few kilometers down, and used pumps to pump out the oil and gas gathered there.

Even though most of the oil and gas still resided in the source rock (typically over 90% of it), they didn't bother drilling through the source rock. That's because the source rock didn't have the cracks that reservoir rocks had.

When you drill a hole into the reservoir rock, you're able to access a big area. As you suck out oil and gas, more oil and gas from the surrounding area move into the newly vacated area via the large cracks in the rocks, which you can then suck out as well.

Unfortunately, this process doesn't happen inside the source rock because there are no channels (i.e. cracks) through which oil and gas can travel through. This meant that oil gas producers wouldn't have pumped a meaningful amount of oil and gas to make it worth their while.

How Fracking Changed The Game

Fracking is short for 'hydraulic fracturing'. Let me describe the process for you.

First, you drill a deep well cased in steel into the source rock. Then, you shoot down some explosives. The explosives perforate the steel casing, as well as providing small cracks in the source rock.

Next, you pump down lots of water mixed with a few different chemicals. You apply extremely high pressure until the rock can't take it anymore, at which point it cracks.

Then, you start pumping out the oil and gas. These cracks act as channels through which oil and gas can travel through, so you're able to recover a lot more oil and gas.

The Impact On Natural Gas Prices

Oil and gas companies discovered that they can apply fracking to tons of places in North America. They started drilling in Texas, in North Dakota, Alberta and many many more states and provinces. Just about every oil and gas company started to frack most of their wells to unlock previously inaccessible oil and gas on their land.

This dramatically increased the supply of oil and natural gas in a short amount of time.

Unfortunately for the producers, there was one problem regarding natural gas. Unlike oil, it's much tougher to transport natural gas across different parts of the globe. Once you produce natural gas, it has to be consumed locally. Some of it can be stored, but storing it is expensive, and there's limited capacity for it.

North Americans built natural gas power plants and other facilities, but we couldn't build them fast enough to keep pace with the supply. As a result, the demand didn't change very much.

When you have a sudden spike in supply versus demand, prices fall. That's exactly what has happened to natural gas.

Where Will Natural Gas Prices Go?

Historically, a barrel of oil has traded around the same price as 6 mcf (thousand cubic feet) of natural gas. That's because 6 mcf of gas has roughly the same energy output as a barrel of oil.

Today, that ratio is far off balance at around 28. This means that natural gas is a much cheaper source of energy than oil today.

This phenomenon won't last forever. Already, many new natural gas power plants are coming online, often at the expense of coal plants. With the increase in demand, it makes sense that natural gas prices will go up in the future. Other investors agree, as natural gas contracts for delivery far off in the future costs more than natural gas does today.

You might think to yourself - "How can I take advantage of this as an investor? Does this mean that natural gas ETFs are a good way to go?" As you'll see in my follow-up post, the answer is surprisingly, 'No'.

Stay tuned.

This blog post was originally published on the blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.