Fracking, U.S. Manufacturing, and Putin’s Crimea

The Russian annexation of Crimea and the continued menacing of Ukraine has given rise to a rather surprising challenge. People are calling for the United States to step up the export of domestically produced oil and, especially, natural gas in order to save Ukraine. The call is not without a logical foundation. Ukraine—a highly inefficient energy consumer—is dependent on natural-gas imports from Russia. While Russia probably cannot afford to cut off the supply to Ukraine completely (most of its exports to Europe pass through Ukraine and would have to be cut off as well), it can manipulate the price, which it has already raised by about 80 percent since the current crisis erupted. Improved energy efficiency and a search for alternative fuels or, at the very least, alternative suppliers must certainly play a role in forging a long-term solution to Ukraine’s problems.

On the other hand, that may not be the actual motivation for the calls to boost U.S. exports. It is worth examining the evolving economic situation in the United States. Before making even a seemingly simple decision, we should note what the possible consequences and opportunity costs are. Every decision concerning the economy involves trade-offs, and those may give hints as to the reasoning behind the proposal. In any event, it is always best to be aware of the trade-offs involved.

The Fracking Revolution

The newest technological innovations in oil and gas production, especially hydraulic fracturing, or “fracking,” are not really all that new, but they are expensive. It is the rising price of oil and gas that has made them viable and brought them into more common use in recent years. Fracking is also associated with potential environmental and health issues that ought to give one pause, but we shall ignore those issues for the purpose of this discussion because they appear to be having little impact on decision making.

For now, the primary consequence of the fracking revolution is a tremendous surge in U.S. domestic fuel production. No, the country still does not produce as much as it uses, but production is increasing rapidly, and if this keeps up, surpluses in the near future are not inconceivable. Obviously, this has a positive impact on the economy, but it is not always the impact that people expect.

First, an obvious benefit would be some more employment in the oil sector. A second direct benefit of reduced imports of expensive oil should be a reduced trade deficit and an improved balance of payments (unless, of course, we spend the savings on other imports). Third, domestically produced oil should reduce reliance on vulnerable trade routes, but the relative improbability of the United States being physically blockaded makes that a less clear benefit.

A fourth point is a bit trickier. Many people think that domestically supplied oil and gas will have lower prices, or at least more stable prices, and a greater certainty of access. Here, given current conditions, there are different answers for oil versus gas.

Oil is fungible and travels around the globe freely in huge ships. It is part of a unified global market. When the price goes up in one place, the oil flows there, pushing the price up elsewhere. When OPEC, or some other producer, raises its price, all the producers raise their price. The price of domestically produced oil will rise just as surely as that of the foreign brands. (In Canada, which exports twice as much oil as it imports, prices spiked just as much in 2008 as they did elsewhere.) Furthermore, if some political or military crisis were to cut off supplies to, say, Europe or Japan, it is difficult to imagine that Washington would respond with, “Hey, we’ve got ours. You should’ve tried fracking.” Supplies will be shared in a true emergency. Yes, there are laws from the 1970s restricting U.S. oil exports, but the president can issue waivers if required in the national interest. Improved domestic supplies of oil do not really guarantee freedom from price or supply disruptions.

For natural gas, the story is a bit different. Whereas a lot of oil moves about the world by ship, most gas travels by pipeline. One distinctive feature of a pipeline is that it starts in one place and ends in another, and those places pretty much stay put. Changing suppliers or customers is a major undertaking, requiring investments in new pipelines or the construction of plants that can cool the gas into a liquid (liquefied natural gas, or LNG), pipelines to supply these liquefaction plants, special ships (refrigerated LNG tankers), and if they do not already exist, facilities in the destination country to offload the LNG and reconstitute the gas.

What this means in the short term is that the U.S. natural gas market is largely cut off from the global gas market. Whereas oil supplies and prices fluctuate with global prices, domestically produced gas is becoming abundant—essentially trapped on the continent—and the price is plummeting. This has had a couple of consequences. First, it has given an added boost to an unexpected revival in U.S. domestic manufacturing. Second, it has created a desire among natural-gas producers to find a way to drive the price back up.

The Manufacturing Revolution

Statistics show that manufacturing has been making a come-back in the United States after years of offshoring production to China and elsewhere.* This has been spurred by several factors. For example, companies have come to realize that there is more to production costs than just labor costs and more to labor costs than just wages. Productivity counts as well. Chinese productivity remains well below U.S. levels. Beyond that, Chinese wages have been rising, while U.S. wages (sadly) have fallen. In addition, the experience of producing half-way around the world and waiting for long lines of ships backed up at the Port of Long Beach has drawn attention to transportation costs, quality-control issues, and problems with on-time delivery. Then there are threats to intellectual property.

On top of all of that, however, U.S. energy costs have been plummeting. Natural gas in the United States is available at a fraction of the cost in Europe or Asia. This has been especially important in energy-intensive industries. American and even foreign companies have been investing in the U.S. production of chemicals, fertilizers, steel, aluminum, tires, and plastics. As a share of GDP, U.S. manufactured exports are at their highest point in half a century. The combination of low wages (adjusted for productivity) and cheap energy have made the United States one of the developed world’s lowest-cost producers.

Gas Prices, Exports, and the Fight for a Free Crimea

The energy industry, naturally, would prefer rising—or at least steady—prices to those that plummet. One way to achieve that is to link the growing U.S. supply to the burgeoning world demand through LNG exports. Energy suppliers quickly pointed out possible advantages, such as generating foreign exchange (driving the trade deficit even further down) and boosting economic growth and job creation. Just as understandably, the manufacturers have been quick to urge caution, fearing that the increase in domestic gas prices that would result from exports could undermine the viability of their expensive new manufacturing infrastructure.

In light of recent events in Ukraine, the energy lobby has added to its list of arguments the importance of exporting to strategic allies who are vulnerable to supply manipulation. The reference to Ukraine is clear and, indeed, often explicit. Producers have called on President Obama and the Department of Energy to hurry the permit-approval process for the construction of LNG-export facilities in order to ease Ukraine’s crisis.

Yet Obama and the Energy Department are not really the problem in this regard. They have already approved seven such facilities. Of those seven, however, only one has also been approved by the Federal Energy Regulatory Commission (a process that can take months or years and over which the president has no influence) and by the state in question (Louisiana in the one case). That project got an early start because it was originally intended to be an LNG-import facility. (Only a few years ago, before the fracking revolution, it was widely assumed that the United States would soon need to import large quantities of LNG.) And, barring unforeseen difficulties, that plant is not expected to be completed before 2017. The remaining six plants, and some 20 other proposals waiting in line for approval, will still have to go through years of business development, engineering, and construction before they are ready to ease Ukraine’s crisis.

I certainly do not mean to belittle the urgency and magnitude of Ukraine’s problems, but that is just the point. The most urgent aspects of Ukraine’s crisis are going to be settled one way or the other long before these plants are ready to address them. True, even after the crisis passes, Ukraine will still need gas imports, but that is not driving the pressure to rush the permitting process, which began before the Crimean crisis. The energy industry is simply looking for ways to drive up prices; the references to trade deficits, jobs, and Ukraine are simply efforts to gain allies in the fight with its real adversary in this matter, the manufacturing industry, which would prefer to keep prices down. Presumably, some sort of accommodation will eventually be worked out, involving some level of manufacturing (less than it might have been) and some level of gas exports (less than it might have been) at a price (higher than it is now) that will cover the costs of gas extraction without stifling economic growth. Hopefully, some of those exports will even go to Ukraine (never guaranteed). Decision makers, however, will be confronted with multiple demands from both sides and need to be aware of the real issues and trade-offs involved.

*Unfortunately, the revival of manufacturing may not be accompanied by an equivalent surge in manufacturing employment. Much of the new manufacturing is highly automated and computerized. Such jobs as are created are likely to be well paid, but not numerous. That said, however, the Boston Consulting Group has predicted 2.5 million to 5 million new factory and service jobs associated with increased manufacturing.