Don’t Fear ‘Fracking,’ Fear The Horrid Illusion That Revived Fracking

In 1980 Julian Simon famously bet modern Malthusian Paul Ehrlich $10,000 that five commodity metals chosen by Ehrlich (he selected copper, chromium, nickel, tin and tungsten) would decline in price by 1990. Simon’s point was that price signals tell producers where their production is needed, so the high prices for the five would serve as a lure to producers on the way to lower prices within ten years.

To this day Simon’s winning bet claims legendary status inside both the conservative and libertarian communities. Simon’s thinking was theoretically correct, high prices if left alone beget lower prices, yet ignored by conservatives and libertarians alike is that commodities are measured second by second in fluctuating dollars, and their prices are far more sensitive to the dollar’s value than they are to changes in supply. The dollar fell to an all-time low (at the time) of 1/875th of an ounce of gold in 1980, but by 1990 it had strengthened to 1/350th of an ounce. In short, Simon’s win had little to do with his broadly correct theory, and everything to do with when the wager took place.

The dollar soared in the ‘80s, and its strength ensured a victory for Simon. Still, had he made the same bet with Ehrlich in 1971 or 2001, Simon would have lost.

The fortuitous timing of Simon’s wager sprang to mind while reading Wall Street Journal reporter Gregory Zuckerman’s (Zuckerman authored the wildly entertaining 2008 book The Greatest Trade Ever) new book about the intrepid men who populate the oil & gas industry, The Frackers: The Outrageous Inside Story of the New Billionaire Wildcatters. Taking nothing away from the genius behind the perfection of an old technology that enables energy entrepreneurs to fracture (hence “fracking”) rock in order to free up oil and gas trapped beneath, a major reason we’ve heard of them has to do with timing; specifically the weak dollar policies that sadly took flight during George W. Bush’s presidency.

Absent a collapse in the value of the dollar since 2001, there’s no oil & gas boom, and there’s no “fracking” renaissance. Zuckerman has an interesting story to tell, his detailed reporting on some truly great men is rather interesting (though not nearly as interesting as those chronicled in The Greatest Trade Ever), but his purposeful or unwitting decision to totally ignore the weak dollar’s role in what’s amounted to an economy-sapping rush into fossil fuels very much weakened his book. That Zuckerman similarly whiffed on the basic economics that define the movement of all market goods also subtracted from what remains a very worthwhile read.

Almost completely missed by Zuckerman is that there’s no accounting for the final destination of anything. This includes oil. One wonders if Zuckerman secretly knew this, but worried that stating the obvious might detract from the heroic nature of the individuals he profiled within?

Whatever the answer, Zuckerman’s purposeful or unwitting ignorance about the flow of goods led him to more than once make outlandish assertions along the lines of increased oil extraction that would end our “fifty-year addiction to oil from countries with interests that many years ago diverged from ours,” or “hand-wringing on Wall Street and in Washington, D.C., about how the United States would meet its future energy needs,” or the advantages of increased domestic production that could improve our defense spending outlook relative to countries like China “that remain dependent on Middle East oil production.”

No sane person, or better yet no one who understands the basics of economics would ever wring his hands with worry over how the U.S. would “meet its future energy needs.” Figure Switzerland and Hong Kong have long been “dependent” on the rest of the world for the production of all manner of goods, including oil, with no ill economic results to speak of for being that way.

Being “dependent” hasn’t hurt them mainly because the very notion of trade involves exchanging what we have and what we’re good at for what we don’t have or what we’re not comparatively good at. Though money is the facilitator of exchange, ultimately we trade products for products. Switzerland and Hong Kong may be bereft of natural resources, or “commodities” like oil, but their genius in the areas of finance, watches and chocolates (to name but three) means they’re able to trade the fruits of their labor for the oil byproducts that they don’t have.

Applied to the U.S., we’re “dependent” on the Japanese for televisions, the Italians for fancy shoes, and Guatemalans for bananas, but far from our dependence impoverishing us, it in fact enriches us. That we import all three frees us up to start Google, Microsoft, and Intel. Even if possible, “energy independence” and “independence” for any market good is a false, economy-asphyxiating concept on its very best day for ignoring the Ricardian wonders of comparative advantage. Read on.

The logical reply to the above is that Switzerland and Hong Kong haven’t aggressively inserted themselves into world affairs, and because they haven’t, they needn’t worry about any country ever ceasing to sell them oil, steel, and other goods. Of course, the latter is wholly irrelevant.

Producers of commodities like oil could surely embargo the U.S., Switzerland or Hong Kong, but if so, so what. Simple economics dictates that there’s no accounting for where products shipped ultimately end up, so assuming all the world’s oil producing nations were to place an embargo on Switzerland and Hong Kong, the citizens of both locales would continue to consume oil and its byproducts as though it were sourced from the waters of Lake Zurich and Victoria Harbor. They would simply buy from those not embargoed. This is true for the United States too. We could be totally energy “dependent,” embargoed by or at war with every oil producing nation in the world, but the citizens of the U.S. would still consume the world’s oil as though it had bubbled up in West Texas.

Of course, that’s what was so disheartening about Zuckerman’s assertion that the “1973 Arab oil embargo served notice that the nation had become reliant on others for its energy needs.” It all sounds intimidating, until we remember that none of what Zuckerman presumes is true. The ’73 embargo in no way shrank our ability to consume “Middle East” oil. To the extent that Arab nations “embargoed” us, we very easily bought the oil from those they did not embargo. Saudi oil minister Sheik Yamani conceded afterwards that the 1973 embargo “did not imply that we could reduce imports to the United States…the world is really just one market. So the embargo was more symbolic than anything else.”

What Zuckerman further failed to relay to his readers is that there were no oil shocks in 1973. As Robert Bartley, the late editorial page editor of the Wall Street Journal explained in his classic 1992 book The Seven Fat Years, “The real shock was that the dollar was depreciating against oil, against gold, against foreign currencies and against nearly everything else.” Commodities across the board, from wheat, to meet, to soybeans, were all rising in price amid the dollar’s fall. In short, the oil “shocks” were dollar shocks, and they would have occurred much as they did even without an Arab oil embargo.

Looked at in terms of gold, the commodity that has historically defined currencies, not much has happened with oil in the last 40 years. In 1971 an ounce of gold at $35 bought 15 barrels of oil at roughly $2.30/barrel, in 1981 after a decade of dollar devaluation an ounce of gold at $480 bought 15 barrels at roughly $32, in 2010 an ounce at $1176 bought around 15 barrels, and right now an ounce of gold buys a little under 13 barrels. What this tells us is that the price of oil hasn’t changed much since 1971, but the value of the dollar in which oil is priced has changed a lot.

Unfortunately, none of this was mentioned, and Zuckerman’s analysis was severely weakened as a result. Indeed, for one to presume to explain the modern rush into oil without mentioning the dollar is the equivalent of an auto enthusiast talking about the Ferrari while totally ignoring the car’s engine in his description.

To fill in what Zuckerman left out, in the seven years leading up to July of 2008 when crude hit a nominal all-time high, the price of oil in euros rose 198 percent, in Swiss francs 216 percent, but in dollars crude had spiked 459 percent. What this unquestionably tells us is that the commodity story of modern times is almost wholly a dollar story, yet despite this tautology, Zuckerman never tied the two together. Had he done so, it would have changed the story he wrote dramatically.

Indeed, Zuckerman quotes Harold Hamm, one of the main individuals on whom he focused for The Frackers, acknowledging that “Rates of return get pretty minimal below fifty dollars.” Zuckerman himself wrote about the Bakken region in North Dakota where Hamm’s fortune was won, that “costs in the region were so high that it didn’t pay to do any drilling unless crude prices were at fifty or sixty dollars a barrel.”

The above is important when we once again consider the direction of the dollar since 2001. Back then the greenback was rather strong, and as such, the price of crude was low; trading at $24/bbl. Assuming the Bush Treasury protects the value of the dollar as the Clinton and Reagan Treasuries did, there’s no subsequent oil spike, and of essential importance, no energy renaissance in North Dakota. The economics of extracting Bakken oil make no sense if the dollar is strong and stable.

Zuckerman reports that by the 2013 “the United States was producing seven and a half million barrels of crude oil each day, up from five million in 2005.” He adds that the increased production “could help keep a lid on global prices for years to come.” It all sounds exciting on its face, but it’s as though the necessarily skeptical reporter in Zuckerman was blinded by his witness to the admittedly exciting innovation taking place in the oil patch. The latter is assumed mainly because Zuckerman’s presumptions concerning price don’t come close to adding up.

Despite a 50 percent daily increase in U.S. oil output from 2005 to the present, there’s been no discernable decline in the price of crude. In fact, the price has soared. While a barrel averaged $50 in 2005, by 2013 the average had risen to $89. All this new supply, yet the price of crude was rising. Zuckerman’s book did very little to explain this obvious disconnect other than occasional mentions of supply shortfalls and gluts.

All that might be fine, particularly to a non-reporter, but one expects more from an award-winning reporter of Zuckerman’s caliber. That’s the case because the supply argument is so easy to disprove. Lest we forget, from 2001 to 2008 when the price of crude saw its biggest jump, most of the spike was in soggy dollars. In euros and Swiss francs, the increase wasn’t nearly as large. Channeling Bartley’s commentary about the ‘70s, the oil “shock” that authored a massive rush into the oil patch was largely a dollar shock. If the dollar stays at levels that prevailed in the late ‘90s and early ‘2000s, the price of oil remains low, and we’ve likely never heard of Hamm, Aubrey McClendon, Tom Ward, and many of the other enterprising men who populated Zuckerman’s book.

This isn’t meant to diminish their herculean accomplishments as much as it’s to say that they’ve achieved great things all the while chasing a money illusion. Oil wasn’t plentiful in the ‘80s and ‘90s only to become scarce in the 2000s. It’s also naïve to presume that OPEC became stingy in the 2000s after “improperly keeping a lid on prices” in the ‘90s as Hamm laughably tried to persuade federal officials. OPEC couldn’t control the price of oil on its best day.  If this is doubted, readers need only get an oil chart from the 1960s (when OPEC came into existence) when the dollar had a stable definition as 1/35th of an ounce of gold.  Oil was flat.

Yet writing about low-priced oil in the late ‘90s, Zuckerman observed that “Almost everyone in the business understood that low oil prices were due to excessive global supply.” Really? So Zuckerman expects readers to believe that despite oil being flat from 1947 to 1971 (the last period of dollar price stability), suddenly prices spiked in the ‘70s as demand soared only to fall back again for two decades as demand declined, only for demand for crude to coincidentally skyrocket in the 2000s?

No doubt there are some readers willing to accept just such a scenario, but then it’s Zuckerman’s job as a reporter to explain to readers why what may seem true in fact isn’t. He could have, and should have, done better. Needless to say, the dollar plummeted in the ‘70s, and with its decline, gold, oil and most other commodities soared. The dollar’s direction reversed in the ‘80s and ‘90s, and the result was that oil, gold and other commodities took a dive. In 2001, the dollar retreated again a la the 1970s, and commodities soared. Despite supply having had little to do with modern oil and commodity volatility, Zuckerman accepted just such an explanation seemingly without protest. The book once again suffered Zuckerman’s decision to not sleuth an obvious red flag that logically subtracts from what remains an interesting story.

To fully ensure that readers will be well versed in what happened, the price of oil averaged roughly $23/bbl. in 2001, but now its price is around $100. On its face the latter spike might speak to scarcity, but consider the objective measure of the dollar’s value that is gold. Though the dollar bought 1/280th of a gold ounce by the end of 2001, by the end of 2013 it bought roughly 1/1300th. The big spike in oil merely reflected a long decline in the value of the dollar.

The same applies to natural gas, the other form of energy that animates Zuckerman’s book. In 1999 it traded around $2.30 per thousand cubic feet, but by 2008 it traded in the $12 range. Quite unlike oil which is priced in global markets, natural gas as Zuckerman acknowledges tends to be comprised by a series of more local markets. Still, the trends were and are obvious; the only difference being that the high nominal prices led to a massive nationwide search for natural gas such that prices in our more local market began to decline by 2012. The latter is cause for a bit more optimism, but it doesn’t change the fact that absent horrid dollar policy as the 21st century dawned, there never would have been this headlong rush into fossil fuels in the first place. Why would there have been? After a decade of heavy exploration and investment, the price of natural gas is merely back to where it was in the late ‘90s.

This is important mainly because as Zuckerman explains through natural gas entrepreneur Charif Souki, markets were already at work to make the importing and exporting of natural gas more feasible. Even if the U.S. were utterly bereft of it, transport innovations and liquid natural gas terminals devised by Souki were and are going to eventually render natural gas a globally transportable good in the way that oil already is.

But going back to oil, particularly oil discovered in North Dakota’s Bakken region, Zuckerman references all the excitement there about the possibility of 20 billion barrels of recoverable oil. Hamm himself exclaimed that “We can be the Saudi Arabia of oil and natural gas in the twenty-first century.” Yes we can if we love persistently lousy economic growth.

Lest we forget, the oil in the Bakken region is only recoverable in an economic sense if the dollar remains historically weak. Assuming a revival in the value of the dollar, a revival that authored stupendous growth in the ‘80s and ‘90s, Bakken’s boom will quickly revert to ghost-town bust.

Conservatives and libertarians alike have rejoiced in the modern rush to fossil fuels, in various ways they’ve said “thank goodness for fracking, without which the U.S. economy would be in big trouble,” but their excitement is wholly backwards. Indeed, the more realistic way to look at this modern energy renaissance is that the rush to energy itself explains our weak economy. The reasons why are basic.

For one, as AEI economist Mark Perry revealed in a post from several years ago, even in its revived state the U.S. energy sector enjoys profit margins that are rather slim. Perry calculated that the sector is the 112th most profitable one in the U.S. This tells us in plain numbers that our giddy return to the energy patch after two booming decades in which energy was largely forgotten has amounted to a retreat to low value, economy-enervating work. Energy extraction in a stable dollar environment would be the work of less economically advanced countries that can extract it far more cheaply than we can, not the profession of the richest country in the world.

Second, economics is about tradeoffs, and thanks to an illusion wrought by cheap money, massive amounts of human capital have migrated to that which isn’t very profitable. Despite this, and despite massive natural gas and oil discoveries, gas prices as previously mentioned sit where they did when the alleged boom began, while the price of oil is four times what it was. What must be remembered is that energy commodities are available at the market price for all comers. Assuming a different scenario whereby the Bush and Obama administrations don’t pursue a greatly weakened dollar, we’d surely be more energy “dependent,” and because we would be, our economy would be a great deal healthier. As importers of the prosaic, we’d be focusing our energies on higher margin concepts as opposed to formerly innovative ones that signal an economy-weakening blast to the past.

Third, it can’t be forgotten that when investors invest, they are buying future dollar income streams. Oil and natural gas are as mentioned least vulnerable to devaluation of the unit of account, so they’ve been the natural recipients of always limited investment amid devaluation of the unit. Not considered enough is what we’ve lost; as in all the investment that would have migrated toward stock and bond income steams representing future wealth creation if so much of our capital weren’t invested in digging up the wealth of yesterday. We needn’t fear fracking as so many environmentalists believe, but we should fear what its revival says about our economy.

Early on in The Frackers, Zuckerman writes about how the “energy boom could generate more than two million new jobs by 2020,” and that “Hiring is on the rise in Texas, Oklahoma, and Louisiana, as well as in Ohio, Wyoming, West Virginia, and Pennsylvania,” not to mention that “North Dakota enjoys an unemployment rate of about 3 percent.” It all sounds great, but oh my, how we’ve seen this movie before. Importantly for readers, the feel-good film ended badly. Very badly.

Back in the 1970s, the last time the dollar was devalued and oil soared, oil patch locales similarly boomed. Midland, TX could claim one of the world’s most profitable Rolls-Royce dealerships. But with the revival of the dollar in the ‘80s, the boom turned into a horror film. As Zuckerman himself notes, “The 1980s were among the worst periods in the history of the domestic energy industry,” and during that decade an “estimated 90 percent of the oil and gas companies went out of business”(my emphasis). As he further wrote about the price collapse, it “forced banks to shut down throughout America’s Southwest, resulting in over $15 billion of bailout costs for the U.S. government.” Coincidence? Not very likely.

Ultimately Zuckerman has written a very interesting book that is full of quality information. While it’s very unfortunate that his analysis ignored the dollar angle, not to mention the truth about how goods flow globally, his reporting on the visionary dreamers who revived a form of drilling dismissed by the major oil companies is very much worth the time of readers.

Still, as Harold Hamm told his chief financial officer no doubt more than once, “There’s oil everywhere, man.” Precisely. And because oil is everywhere, it’s no mystery why our economy is weak amid a renaissance for U.S. energy exploration. The latter speaks to our retreat into the prosaic, into a search for a market good that is easily attainable. That’s the stuff of economic stagnation.

The good news is that this can be reversed by a return to the dollar policy that authored a massive U.S. and global economic boom in the 1980s and 1990s. Indeed, we’ll know the economy is in growth mode once energy extraction is in our rear-view mirror. Fracking once again isn’t a problem, but the monetary policy that gave it modern life very much is.

Forbes