The Political Economy of Fracking

Private Property, Polycentricity, and the Shale Revolution

Ilia Murtazashvili, Ennio Piano

• Publisher: Routledge
• Year: 2018
• Topic: Economics
• eBook ISBN:
  9780429852701
• Subtopic: Business General
• Index: Economics

Over the past two decades, "fracking" has led to a revolution in shale gas production. For some, shale gas promised economic opportunities, cheaper energy bills, and an alternative to coal. For others, shale gas was fool's gold. Critics contend that the shale boom has occurred in a regulatory Wild West, that the response has been fractured and ineffective, or that the harmful environmental and health consequences exceed the benefits from shale gas production.

The Political Economy of Fracking argues that the criticism of the shale revolution has been misplaced. The authors use insights from a diversity of perspectives in political economy to understand why the shale boom occurred, who won in the race for shale, and who was left behind. The book explains how private property rights and entrepreneurs led to the shale boom. It contends that polycentric governance, which encourages a diversity of regulatory responses, is a virtue because it generates knowledge about the most appropriate ways to regulate shale development. Private property rights and political institutions that provide for local self-governance also helped to ensure that the benefits of shale gas production exceeded its costs.

The authors make the case for fracking shale gas using evidence from shale-producing countries from around the world, comparing them to those that have fallen behind in the shale race. They show that private property rights and markets have been a source of innovation and dynamism and that a diversity of regulatory responses is appropriate to govern shale gas development. This book is insightful reading for academics and professionals interested in the shale boom, the fracking industry in general, and regulatory policy.

1

Introduction

“Fracking” is a catch-all way to describe a technique used to extract natural gas trapped in rock formations known as shales. People began referring to the process for extracting shale gas as fracking even though the technique of fracturing rock has been used to capture shale oil since the 1950s. In our book, we will follow the popular convention and refer to the process of extracting shale gas as fracking, although a more accurate description of the process is “high-volume hydraulic fracturing of shale to extract gas.” That is a mouthful, so we will just call it fracking in this book, with the proviso that fracking is not limited to gas.

Our focus on shale gas does not deny the obvious economic importance of shale oil. In fact, the USA has around 58 billion barrels of technically recoverable shale oil, ranking second in the world only to Russia, who has 75 billion barrels. In the summer of 2018, the Wall Street Journal documented in several articles the consequences of the substantial increase in shale oil production from the Permian Basin in western Texas. Some of the consequences included a shortage of truck drivers (Elliott and Smith 2018), as well as record orders for new big rigs by major trucking companies operating in the region (Page 2018). Much like shale gas, those developments also reflect the ability of markets to solve economic challenges, as the increase in demand for drivers and big rigs led to substantial increases in wages to attract drivers, as well as building more rigs.

Despite the importance of shale oil, it was shale gas that brought “fracking” to forefront of public debates. Nor has shale oil been subjected to the intense social and political conflict that has accompanied the boom in shale gas production. Indeed, before the boom in shale gas production, we are unaware of much public debate about fracking shale oil. Even today, there is not nearly as much concern about fracking shale oil as fracking shale gas. Perhaps most importantly, shale gas development occurs over much larger areas than fracking shale oil, and so its consequences are much more widely felt.

The reason for our focus on the USA is because it has become a world leader in natural gas production because of fracking. The USA also has vast quantities of shale gas, which means the energy revolution is not going to end anytime soon. Shale gas can be measured using a bottom-up or top-down approach. The bottom up approach, emphasized by geologists, considers volume and content of minerals. The top-down approach, emphasized by oil and gas companies, considers what is technically recoverable, and depends on technology, which determines well productivity. The economically relevant approach is the top-down approach because it determines what is economically profitable. According to the top-down approach, there is a tremendous amount of shale gas, especially in North America, where each country has enough shale gas to meet the demands of its economy for several decades. Table 1.1 lists the amount of shale gas in the top ten shale-producing countries in the world. The focus on the USA (and to a lesser extent, Canada) makes sense, as a quarter of world reserves are located there.

TABLE 1.1 Top 10 countries with technically recoverable shale gas

Rank	Country	Shale Gas(Trillion Cubic Feet)
1	China	1,115
2	Argentina	802
3	Algeria	707
4	USA	665
5	Canada	573
6	Mexico	545
7	Australia	437
8	South Africa	390
9	Russia	285
10	Brazil	245
	WORLD TOTAL	7,299

Source: US Energy Information Administration (2013)

Although fracking shale gas was a surprise to many, the shale revolution was a long time coming. Geologists have known for over a century that shale contains natural gas, and drillers have been trying to figure out how to liberate it for decades prior to the shale boom. The technological challenge with shale gas lies in the fact that it cannot be profitably extracted from shales by the standard method of drilling downward and relying on natural pressure to force valuable minerals to the surface. The reason is that the shale is too impermeable. In this regard, it is not as easy to extract as is suggested by Steve Stockman, a former US representative from Texas, who once tweeted that “[t]he best thing about the Earth is if you poke holes in it oil and gas come out” (Berman 2013). When it comes to shale oil and gas, simply poking holes on the ground will do nothing.

The issue of depth is an important one in thinking about gas. Figure 1.1 illustrates the contrast between unconventional and conventional gas, and a key difference: shale gas is lower, and embedded in rock. The figure also shows coalbed methane. The extraction of coalbed methane has had a major impact in places like Wyoming in the western USA (Fitzgerald 2012, 2010). Coalbed methane is closer to the surface, and easier to extract, and has important economic consequences, although it has not been subjected to anywhere near the scrutiny of fracking shale gas. “Tight” gas usually refers to natural gas housed in sandstone (or limestone).

FIGURE 1.1 Conventional versus unconventional gas

Source: US Energy Information Administration (2011)

Fracking changed the economics of “unconventional” oil and gas, that is, oil and gas that cannot be extracted by drilling downward. Fracking involves drilling wells reinforced with concrete and steel downward (to depths of several thousand feet below the earth’s surface) and then horizontally before fracturing rock with chemically-treated water. The chemicals make the water slick; without them, the water gums up the machines. Fracking made extraction of unconventional gas, including shale and tight gas, economically profitable.¹ These techniques of extraction made production of shale gas an economic reality.

This is a book about the shale gas revolution. Of course, the political, economic, and social consequences of shale gas development are remarkably complex. To preserve the clarity of the discussion, we decided to organize our book around a few specific questions. Why is that drillers in the USA, specifically on the shale basins in Texas, were the ones who figured out how to profitably frack shale gas? Why did the American economy respond so rapidly—especially with a quick process of contracting between gas companies and mineral rights owners—to new economic opportunities presented by fracking technology? How effective was the regulatory response to new challenges posed by hydraulic fracturing? Is self-governance of fracking, whereby political institutions allow for local variation in policies to govern shale gas development, a virtue or vice? Why have some economies led in the shale boom, while others have fallen behind in the shale gas revolution?

To answer these questions, we adopt a political economy perspective. More precisely, we use insights from several political economy approaches. We believe that a diversity of intellectual traditions can offer us precious insights into the operation of political-economic systems, including institutional economics, Austrian economics, the Bloomington School of institutional analysis, and public choice theory. Briefly, these perspectives emphasize (respectively) how the rules of the game shape economic incentives, the importance of the entrepreneurial market process and the nature of the spontaneous order of the economy, the virtues of self-governance, and the incentives faced by political agents. Boettke and Leeson (2015) refer to these schools of thought as having different “political-economic presumptions.” Despite key differences in each perspective, there are many affinities between these approaches and they offer complementary insights into the process of economic development. Later in this chapter, we provide a richer description of our approach to political economy. But first, we wish to introduce the themes of the book by way of an example.

The example we chose to illustrate the book is from Robinson, which is a town in Washington County in the southwest part of Pennsylvania, on the border with West Virginia. Robinson sits atop the Marcellus Shale, which along with the Utica forms the Appalachia region shale basin that spans several states in the north-eastern USA, including much of Pennsylvania and New York. The Marcellus is now the most productive shale play in the USA.

Robinson is a small town with about 2,000 residents. Historically, its community has survived on coalmining and farming. It is also much like other rural communities in the state in terms of its politics. After the 2016 election of Donald Trump, scholars have emphasized the “politics of resentment” and economic anxiety as contributing to Trump’s support (Cramer 2016). Perhaps as a reflection of those economic anxieties, Trump bested Hillary Clinton by a 2–1 margin among Robinson voters in the 2016 election. Unlike most communities with similar characteristics, Robinson contains shale gas. And not just a bit of it. Indeed, Robinson sits atop some of the richest shale in the entire world. The gas lies about a mile beneath the surface of the land owned by its residents. Gas companies wanted access to it, and many of those who owned the mineral rights wanted those companies to have at it.

Shale promised riches, or at least a couple thousand dollars per head, to many Robinson residents. This prospect of individuals striking it rich because they own rights to oil and gas is quite unlike much of the rest of the world, where the government owns the mineral estate, while individuals often own the surface estate. Private ownership of minerals gave many of Robinson’s residents the opportunity to lease their land to gas companies. But ownership of the underground minerals is not always straightforward. In some cases, for example, the estate might be split, with different parties owning the surface and mineral estates respectively. In those cases, the landowners have to allow development of the mineral estate, which can and has in some cases resulted in conflict, although the mineral rights owners in any case have economic incentives to contract with the gas companies.

The property rights regime also created economic incentives to lease the mineral rights to gas companies. Most contracts to lease mineral rights specify three key provisions: a bonus, royalties, and the length of the lease. These corporations can pay several thousand dollars per acre to lease land, which is often referred to as the bonus. In Pennsylvania, gas companies are also required to pay royalties of at least 12.5 percent of the profits once production starts. Landowners can bargain for a larger share of the profits; 12.5 percent is the legislatively-mandated minimum in Pennsylvania, which is provided for in the Guaranteed Minimum Royalty Act (GMRA). The GMRA protects the interests of owners of mineral rights who may not know much about the value of their property, although the law allows post-production costs to be deducted from those payments. When there are such deductions written into the contract, royalties are likely to be less than 12.5 percent. They may also be less than what the owners anticipated when they signed the lease, especially if they did not read the fine print in the contract.²

Scholars are still wading through the data to figure out just how much has been paid to the owners of these mineral rights. However, all of the major studies—which we review later in the book—find substantial royalty payments made in areas with shale production. Even though there would be some disputes over the amount of royalties received versus what landowners expected, people in communities like Robinson were correct to anticipate that shale gas would bring substantial payments to individuals lucky enough to own mineral rights.

Fracking shale gas also promised to benefit local governments. Once shale production begins, local governments can increase revenue directly or indirectly. The direct way is through a severance tax or impact fee on shale gas development. Pennsylvania eventually established an impact fee, rather than a severance tax, on shale gas development. The impact fee distributes some of the revenue from shale development to communities. Local government revenue can also increase when a shale boom increases economic activity, such as through sales taxes. Presumably, shale gas meant more workers, more consumption, and more revenue from sales taxes.

Like most communities with shale gas, landmen played a significant role in Robinson. Landmen are private contractors who bargain with landowners to lease their land. Once engineers figure out where the shale gas is located, landmen are usually the first on the ground. They sort out who owns the mineral rights so that the gas companies can contract with owners—a necessary step before production can begin.

Figuring out the optimal ownership structure can be complicated, even when much of the land and minerals are privately owned. The reason is that some who own the mineral rights might be absentee owners. Someone has to track them down, as well as get them to sign a lease to mine gas. The primary economic function of landmen is to figure out who, exactly, owns the rights to the underground minerals, negotiate with owners, and if the negotiations are successful, draw up a contract between them and the gas companies. These contracts usually give the latter rights for five years before the agreement must be renewed. The challenge of assembling leases is substantial, as gas companies must secure rights to minerals below large areas of land—sometimes over several square miles. Landmen help to overcome these contracting challenges.

These contracts are good examples of a mutually beneficial exchange. Indeed, they would be beneficial to both parties even in the absence of royalties. Landowners receive a bonus even if there is no production. Royalty checks come in once production begins, although for reasons noted, sometimes people do not read the fine print in the contract about post-production costs. In any event, the clear economic incentives to sign leases help to explain why the leasing process occurred rapidly and, to the best of our knowledge, without much conflict.

The rapid market response to these new economic opportunities contrasts with the response of the local political process. Robinson’s government was slow to issue permits to gas companies even though the market had spoken. These delays meant no drilling and no royalty payments for those owners who signed leases. It also meant no profits for the gas companies.

Gas companies did not stand by idly as the local government tried to deny them the opportunity to develop the mineral rights they had lawfully leased. They were now the residual claimants in production, with a lot to lose from idle wells. Range Resources, one of the largest American gas companies, sued the local government to give them permits. The company believed that the state’s oil and gas laws pre-empted local governments from regulating shale gas development.

The gas companies had a compelling case. In the American federal system, state and local governments have a great deal of regulatory authority to promote the health, safety and welfare of the citizens. Vincent Ostrom (1994) emphasized that such powers are essential to the American system of self-governance. Yet the states—not local governments—have always been the foundation of self-governance. The Constitution is explicit that all power not given to Congress is reserved by the states. Cities are created by the states, and although cities have autonomy, they typically are considered to be subordinate to the state, unless the state says otherwise.

Without getting into the constitutional details, the upshot of legal decisions involving the balance of authority between the state and local governments is that the state can regulate oil and gas when it is explicit about its desire to do so. But there is also an economic logic behind the role of state governments, rather than local governments, in regulating oil and gas extraction. If local governments could regulate oil and gas themselves, then oil and gas companies would potentially have to deal with dozens, if not hundreds or even thousands, of different local regulations. A regulatory jigsaw puzzle in which all localities had their own regulations on oil and gas development would make it challenging to do business, or at least increase the cost of doing business. For example, Pennsylvania has over 2,500 local government entities, with hundreds in shale-rich areas, each of which could potentially develop their own shale gas regulations if given the opportunity.

The government of Pennsylvania began to rewrite some of its oil and gas laws as the Robinson case was making its way through the courts. The main law was Act 13, which we consider in greater detail later in the book. For now, it is sufficient to mention that its key provisions include establishing a model ordinance to govern shale production and an impact fee that promised to redistribute some of the wealth from shale production to local and county governments.³ The model zoning ordinance explicitly denied local governments the right to prohibit hydraulic fracturing.

The model ordinance established a common local regulatory framework for shale gas developm...

Table of contents

• Cover
• Half Title
• Series Page
• Title Page
• Copyright Page
• Table of Contents
• List of illustrations
• Preface
• Acknowledgements
• 1. Introduction
• 2. Private property rights, entrepreneurs, and the shale revolution
• 3. The regulatory response
• 4. Why regulatory diversity makes sense
• 5. The consequences of the shale boom
• 6. Why some states were left behind in the shale boom
• 7. Why some nations were left behind in the shale boom
• 8. Conclusion
• References
• Index