There is nothing like a row of tanks to focus attention. For the EU, Russia’s invasion of Ukraine has not only drawn public attention to the need to reduce dependence on Russian energy, but it has also added impetus to efforts to move ahead with one of the most controversial paths to energy security – fracking.
Russia supplies about 30% of Germany’s natural gas, and 50% or more in Poland and other countries. And yet Poland, the UK, and France sit atop abundant reserves of gas and oil trapped inside rock formations.
Tapping into those reserves could help reduce Russia’s economic leverage – and boost EU industries struggling against US competitors that enjoy low energy costs. UK Prime Minister David Cameron called on the EU to tap all sources of energy to reduce Russia’s influence. “Energy independence,” he said at a March press conference in The Hague, “should be a tier-one political issue from now on.”
Score one for fracking. This would create numerous direct and indirect investment opportunities, ranging from exploration and drilling companies to the services that supply the industry – from drilling-rig manufacturers to firms that make the tubing used to drill horizontally into rock, and the chemicals used in the high-pressure water blasts of hydrofracturing. Infrastructure to process and transport shale energy offers other investment opportunities.
But investors looking for a boom akin to in the US will be disappointed, warn industry analysts. Some estimate that Europe is a decade behind, largely due to policies favouring clean energy like wind and solar, regulatory delays, and unfavourable taxation. What is more, most fracking equipment is in the US, and the geology of the UK and Poland might require different technology to release shale energy.
Boomtown, North Dakota
While shale production requires significant capital investment, the US experience shows how big the payoff can be. Shale gas has rejuvenated the US manufacturing base in steel, chemicals, plastics and fertiliser, while attracting investment from non-US multinationals seeking lower energy costs. Just a decade ago, conventional wisdom held that petro-chemical plants and downstream factories in plastics, rubber, and metals would be built primarily in Asia. Energy consultancy IHS Chemical estimates that $125bn (€91bn) of investment stemming from the US energy boom have been announced so far, and the American Chemistry Council says major companies are building or expanding 48 facilities because of plentiful natural gas.
Those are the early returns from the energy revolution; the New America Foundation projects cumulative capital expenditure in shale gas will increase from $33bn in 2010 to $1.9trn by 2035, when the industry will support more than 1.6m jobs and generate nearly $1.5trn in federal, state and local taxes and royalties. The bonanza also offers the potential to revamp industries such as transportation and electricity generation. More than 15% of US coal-fired electric generation capacity is being retired, says Jason Selch, portfolio manager of Iroquois Capital’s Energy fund, benefitting companies that run gas-fired plants, such as Calpine Corp, which Selch says is trading at a discount to its asset value.
However, energy investment in the EU presents a stark contrast to the US and a reminder of Russian influence in a sector where government intervention has ravaged profitability. German utility RWE, struggling to offset declining profits at its power-generation unit, recently sold its profitable gas and oil production unit for €5bn to L1 Energy, an investment vehicle controlled by Russian billionaire Mikhail Fridman. Under pressure from government-subsidised renewable energy sources, RWE last year posted its first net loss since 1949. Although the German economic ministry said the move did not threaten Germany’s natural gas supplies, it is hard to see how the sale loosens Moscow’s grip.
The recipe for successful exploitation of shale energy contains four key ingredients, says Christopher Wheaton, who manages the $100m energy fund at Allianz Global Investors. “Like baking a cake, you’ve got to have these things mixed in,” he says.
Perhaps obviously, the first ingredient is “good rocks”. Second, well-developed gas and oil production companies and a first-rate energy services sector. Third, a regulatory regime designed to enable permission and supervision in alignment with environmental and community interests. Finally, logistical systems – storage tanks, pipelines, rail, road and distribution networks – to deliver energy to end-users.
In each of the four areas, the “UK and EU score much worse than the US,” says Wheaton. That presents the challenges of which investment opportunities are made. “The crunch time for this industry in the EU will be the next 12-18 months,” he adds.
The first opportunities centre on geology. Each shale resource is unique and the investment universe reflects the pace – and success – of efforts to identify, quantify and extract energy. Opportunities range from directly investable small-cap energy stocks, to private-equity deals and major oil company joint ventures that would provide indirect participation in the shale-energy story.
Early hopes focused on Poland, but test results were mixed and onerous tax and permitting policies slowed the pace of exploration. The leading company, London-listed San Leon Energy, has been trying to tap Polish gas since the initial estimates of huge reserves were released three years ago. After poor initial tests, three major firms, Exxon Mobil, Marathon, and Talisman Energy, exited Poland, leaving junior partners such as San Leon in control of licences.
San Leon has demonstrated how technological innovation may be necessary to tap the gas in Poland’s deposits, which are harder to exploit than US shale formations. In January, the company announced a successful shale test at a site near Gdansk, after replacing the typical sand grains of the proppant pumped into rocks to keep fracture lines open with tiny ceramic marbles.
The European story is attracting US entrepreneurs. In March, US-listed Transatlantic Petroleum took over nine San Leon projects in Poland. Transatlantic is controlled by Malone Mitchell III, an independent US gas and oil producer that is using technology developed in the US to enhance or commercialise production in Turkey, Bulgaria and Romania. The Polish deal allows Transatlantic to recover gas in the Permian Basin, which could be a platform for other EU sites: Poland’s Permian fields are analogues to those in the UK and Dutch sectors of the southern North Sea and onshore Holland and Germany. As the firm’s pitch book for the deal puts it: “Geology doesn’t stop at the border.”
The UK surpassed Poland as the hot spot for shale-gas exploration when it changed its energy policy. The government went from enforcing a fracking ban to offering tax credits for shale-gas production, says Selch. UK shale gas is found in rock formations in the South East, the Weald Basin, and the Bowland Basin in the Midlands. One of the most significant prospects is the partnership struck in early January between the UK’s IGas Energy and French energy major Total to explore and develop reserves in the Midlands. Facing a fracking ban at home, Total took a 40% stake in gas fields licensed for fracking to IGas and Egdon Resources, and privately held Dart Energy. Wheaton’s fund held a 6.8% position in Total at the end of February, with more than 26% of assets in the UK compared with 16% for the benchmark.
Total’s first step will be to drill and test exploration wells to assess the quantity of gas and the structure of the deposits. Expectations are running high. Another UK firm, Cuadrilla Resources, says it has located 5.6trn cubic metres (200 tcf) of gas in the Bowland Basin – enough that even a modest recovery rate would make a significant difference to the UK market, which consumes about 962bn cubic metres annually. Centrica, the owner of British Gas, recently bought into fracking licences owned by Cuadrilla. While testing is under way at IGas’ sites, Jeffries says its shares do not reflect the value of its East Midlands shale reserves – it has a target price of 195p (€2.35) for IGas, which currently trades at 122p.
As energy majors jump in, winning local support is still a challenge. This highlights the biggest difference between the US and EU, says Geoff Jay, sector team leader for energy at Janus. “In the US, people own the rights to minerals under their land.” That creates an incentive for property owners. In the EU, the state owns mineral rights, and local communities question why they should allow fracking if it will not directly benefit them.
That makes the UK’s situation a tale of two cities, says Selch. In the Midlands, high unemployment and damage from the decline of coal mining make local authorities most likely to allow fracking because of the jobs it would generate. Residents in the wealthier south east are far less likely to allow fracking. As Transatlantic noted, geology does not stop at the border. But economic incentives to blast gas out of shale formations just might. And that may determine which fracking licences turn to gold.