Commodity investments: Why the shale revolution will make oil price shocks a thing of the past

Because of today’s high government debt, high joblessness and high deficit spending, many people expect we’ll have to suffer through rising taxes and weak economic growth for the next decade. This belief makes sense, but only if you disregard recent developments in energy.

Before the start of the financial crisis, pessimists used to look on spikes in oil prices as the greatest threat to the world economy. Oil is a key factor in a lot of industrial activity, as a raw material or as fuel for transportation. Oil is also concentrated in a few locations around the world, particularly the Middle East, so it’s vulnerable to transport bottlenecks that result in supply shortages.

When oil prices shoot up, the economy suffers. This, though, could change in the next few years due to the development of oil and gas production from shale and other so-called “tight rock”.

Commodity investments: As oil prices fall, the world economy will grow faster

Shale oil and gas discoveries are turning up all around the world. New technology can bring these finds to profitability in as little as eight months, compared to two years or so for many conventional finds.

The obvious direct benefit is that this new source of supply will weigh on oil and gas prices. This will act like a tax cut in countries that invest in shale production, and will spur economic growth. It will also attract capital to these commodity investments in many countries, but particularly in the U.S. and western Europe.

In addition to cutting prices, this diversification of oil supplies will tend to smooth out fuel prices, by eliminating bottlenecks. When periodic oil shocks become a thing of the past, the world economy can grow even faster.

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Commodity investments: Shale development will boost oil production as well as natural gas

This will depress the profit margins of current oil producers, and that’s a good thing. Many of today’s top oil-producing countries have been corrupted by their oil wealth. Oil gave them all the money they needed, and provided little incentive to build the legal and physical infrastructure for other types of economic activity.

When these countries find their concentration on oil is hurting them, they may start to modernize their politics and business practices. Meanwhile, they may raise their oil production to force oil prices down. This will cut the incentive, at least temporarily, for western countries to invest in shale oil and gas.

Of course, environmental opposition could also slow the rise of shale oil and gas production. The shale industry, like any new industry, needs to develop environmentally safe operating procedures.

Right now, the most controversial procedure is the hydraulic fracturing, or fracking, of hydrocarbon-bearing shale. This process involves pumping a mix of water, chemicals and other materials into shale rock formations that contain oil or natural gas. This fractures the rock and releases the oil and gas. Some environmentalists are worried that fracking chemicals will leak into drinking-water supplies.

But governments have to weigh environmental opposition against the vast increase in jobs and tax collections that shale development will bring.

Lots of investors today vastly underestimate how much oil will come out of shale production, and the effect it will have.

Tomorrow, we will look at a specific example of a company that stands to benefit from the shale oil and gas revolution.

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