Hydraulic Fracturing in Context: Key Institutional Features of an Evolving Technology

Timothy Fitzgerald* (timothy.fitzgerald@montana.edu)

Introduction

Hydraulic fracturing (fracking) has caused a frenzy among a variety of groups interested in energy use.  Interest ranges a wide spectrum: from boosterism by energy analysts who recognize the essentiality of fracking in adding unconventional reserves to widespread concern among environmental advocates and some residents about the unseen and unanticipated effects of its use on human and ecosystem health.  In particular, concern about groundwater supplies has been paramount.  Although fracturing has been known and used for decades, in the past fifteen years technical advances have furthered its use to the point that it resembles a new technology.  These advances have been impelled by efforts to replace depleted resources with unconventional deposits such as shales.  By using improved fracking techniques, new fields in areas unaccustomed to energy development have been opened and older fields have been reentered.  Recent work by Osborn et al. (2011) has provided a scientific link between fracking and groundwater contamination.  This discovery is important and has increased calls for new regulation.  Taking stock of the existing institutional environment provides valuable perspective for policymakers as new regulations are considered.  The salient features that an effective regulation must consider are addressed here.

Fracking has proved essential to natural gas supply by allowing the development of shale gas on a commercial scale.  Clean-burning natural gas is often viewed as a preferable “bridge fuel” in contrast to coal or oil in light of concerns about climate change.  Energy security advocates are also thrilled at the prospect of fracking boosting domestic reserves.[1]

From an environmental standpoint, fracking presents complex and subtle tradeoffs.  On one hand, it has drastically increased the availability of natural gas, a relatively cleaner fossil fuel.[2] This increased supply has helped keep prices low, with attendant welfare gains for consumers.  It also, in conjunction with advances in directional drilling, has allowed more mineral development with less surface disturbance.  To the extent that fracking contributes to secondary recovery, it helps keep development in areas historically accustomed to oil and gas operations.  However, it also opens new resources in provinces unfamiliar with industrial production.  Extensive development entails ecological and social disruption.  The net environmental effect of fracking is therefore unclear, and underlines the delicacy of implementing new regulations.  Making fracking prohibitively expensive could perversely lead to more environmental disturbance and higher product prices for consumers.

While expanded development has raised a number of environmental concerns, the most serious is over the potential contamination of potable groundwater.  Two distinct avenues have been posited: direct commingling of the hydraulic fracturing fluid (a slurry of water, sand, and chemical additives) and water resources; and infiltration of natural gas into water supplies.  While the health effects of methane-infused water supplies are not well-documented, some of the additives to fracking fluid are known carcinogens (others are benign).  This concerns residents with water supplies near oil and gas wells.  At least two instances of presumed fracturing fluid contamination have been documented; both were in Wyoming.[3] Others are suspected but not verified.[4]

Osborn et al. (2011) is the first study that makes a causal link between fracking operations on gas wells and methane intrusion into shallow groundwater wells.  The study has three major conclusions: methane targeted by gas developers has seeped into shallow domestic water wells; contamination by fracturing fluid is not found; and the annulus around fractured gas wells is determined from the data.  The study area was the Marcellus shale in New York and Pennsylvania.  In addition to documenting the higher incidence of potentially harmful methane concentrations, the authors are able to rule out natural background methane contamination as the culprit.  This leaves some unspecified channel of underground fractures or leaking well casings that permit thermogenic methane to appear in shallow aquifers.  The authors recommend further study of the potential pathways, which include poor well completion practices. The study finds no evidence of direct contamination by the fracking fluid.  Because fluid additives have been a primary concern, their absence is significant.  The pertinent annulus around fractured wells was 1 kilometer—water wells within that distance were on average affected, while those beyond were not.  Higher methane concentrations were noted as far away as 1.5 km.  This suggests that effects are fairly local, though many individuals could be affected in that area.

More work is clearly needed to completely map out the production function of fracking and its potential pathways to human and environmental harm.[5] Fracturing jobs are often well- or formation-specific, so the effects are likely to be heterogeneous.  Results from the Marcellus shale may not be applicable in Colorado; proximate health effects from different formations in Wyoming may be totally different from each other, or perhaps even more similar to other locations.  Conclusive economic impact estimates will have to wait until engineers and hydrologists can provide more insight into the pathways for and extent of damages.

In light of these recent findings, it is increasingly likely that fracking will be regulated more in the near future.  It is important to understand fracking within the existing institutional context of oil and gas development, and in this sense economists can contribute to the debate.  There are three key components.  Property rights to minerals and water are often separated.  Bundling varies—in some cases the water user owns the minerals and in other cases the minerals are severed.  These alternative arrangements deserve attention since they may affect the distribution of gains and benefits.  Oil and gas development entails numerous contracts: between developer and mineral owner, surface user and developer, fracturing specialist and well operator, and other subcontractors.  Understanding the structure and adjustment of contractual terms focuses attention on existing gaps where additional regulation might be desirable.  Finally, oil and gas development is highly regulated.  Some existing regulatory structures may be easily adapted to minimize economic losses associated with fracturing.  Oil and gas is already a heavily-regulated industry, and duplicating regulatory effort may not be efficient.  This is especially true when new regulators potentially face a steep learning curve to familiarize themselves with current practice.  Each of these three issues is addressed in turn.

Property Rights

One critical question is: who owns what when it comes to fracking?  Who owns the process that creates damages?  Who owns the assets that are impacted?  The distribution of asset ownership sheds some light on the potential need for regulatory intervention.  Ownership of minerals, surface, and water can be separated or combined.  The degree to which the ownership and control of these assets is separated determines in large part the possible benefits of regulatory intervention.  Four aspects of property rights deserve mention in this context: the issue of severance, the potential for internalization in the absence of spatially-fragmented ownership, the prominence of agency problems, and the effect of liability rules.

The severance of mineral rights from surface rights is a common situation that can complicate the economics of adverse impacts from hydraulic fracturing.  Commonly known as split estate, this ownership structure may prevent internalization of externalities.  In a unified estate case, the owner and putative water well user is jointly maximizing the value of the groundwater and minerals.  The net economic cost of water degradation might be negative.  However, if the mineral owner leases (or develops) the minerals, a surface owner using a water well might not be compensated beyond the damages created.  Severance is important regardless of the spatial extent of effects from fracking, which create a different property right issue.

The central question raised is the spatial extent of impacts vis a vis the spatial extent of property rights.  If the effects of fracking are internalized among owners, then there is less of a problem than if the effects extend beyond property boundaries.  In the latter case, high transaction costs are apt to prevent any kind of Coasean bargaining.  Larger parcels of property would be more likely to internalize problems, whereas many relatively small owners might spread (small) damages over many parties, creating a free rider problem.  However, the likelihood of parcels being large enough to prevent the type of impacts identified by Osborn et al. (2011) is observable before wells are fractured.  Consider the effect of 40-acre well spacing when a 1-kilometer annulus describes the bound of effect.  The affected area is nearly 775 acres, in which as many as 18 other similar 40-acre parcels might suffer from contaminated water.[6] In some areas 775 acres might not be a major concern, such as in the case of large landowners in the West.  More fractionated ownership is likely to lead to higher transaction costs and an argument for regulatory protection.

Agency problems between owners and renters pose an additional confounding factor.  Alternative property rights allocations affect the incentives of affected parties.  In the case that the unified estate owner does not use the water, or has a renter who uses the water, the costs of monitoring water quality and verifying damages may outweigh the expected benefit of doing so.  In such a case regulation might have an important role to play.

A fourth issue is liability, insofar as the burden of proof lies with the damaged party in a strict liability legal scheme, the transaction (or verification) costs might be large relative to the damages.  If split estate is pervasive, a different compensation scheme would be needed to maintain a Pareto optimal allocation than if ownership is largely unified.

Contracts

Contracts abound in oil and gas development.  Depending on the property rights allocation, the contracts in place prior to fracking are apt to vary.  Contracts are directly related to property rights since non-owners will generally not be protected by any contract.  The number of non-owners in the affected annulus is an important consideration for any regulator.  Analyzing contracts involves three elements.  First, the pertinent contracts have to be identified.  Second, affected parties exposed without any contractual protection need to be recognized.  Third, as more information becomes available to landowners about fracking, the terms of contracts are apt to adjust to address environmental concerns.  Because the terms of such contracts are typically private, tracking these changes is difficult.

Before a well is fractured on leased minerals a lease agreement is signed.  Before an operator can enter on severed minerals, a contract is usually signed with the surface owner specifying how development will proceed and damages will be considered.  As effects of fracking become better known to owners, these contracts are likely to specify baseline water quality that must be maintained.  That has been the experience in coalbed methane development, where dewatering coal sometimes dries domestic and stock wells.  Contractual solutions to methane intrusion into water wells may prove cheaper and more flexible than top-down regulations.  The costs of verification and contract enforcement, while significant, may be lower than those imposed via regulation.

A potential problem with contracting is the asymmetry of information between developers, who are likely to have higher technical understanding of fracking, and mineral owners, who may understand little about the technological side effects of fracking.  Perpetuating the information asymmetry are “trade secret” provisions regarding the release of certain ingredients in fracturing fluid.  Fracturing is a competitive, if concentrated, field.  While revealing the chemicals that constitute the bulk of the fluid used, several states have allowed firms to protect the identity of some of the minor ingredients.  This protects information rents acquired by fracturing firms at the expense of maintaining the information disparity.  When information asymmetries persist, contractual solutions are less likely.

Regulatory Environment

A final important dimension of the institutional environment is the scope of existing regulatory oversight.  State oil and gas commissions review well permits.  This review addresses legal and engineering criteria such as well construction and spacing.  Daintith (2010) documents the history of well spacing regulations.  Conservation and trespass concerns were paramount.  The creation of negative externalities on water users simply magnifies the technical externality or trespass concern into another resource dimension.  Taking that effect into account is not beyond the scope of the existing regulatory review for drilling permits.  In the event that stricter regulations are needed to prevent welfare losses from fracking, consideration of the complementary regulatory environment is important.

States also administer federal regulations under the Clean Water Act, so the state environmental quality board often reviews parts of development plans.  Jackson et al. (2011) suggest that Pennsylvania authorities might simply need to expand the affected annulus around each fracturing job.  If effects on well water quality are observed up to 1.5 kilometers away, permitting could explicitly consider potential damages in that neighborhood.  In cases where producing or exploratory units are formed, all neighboring owners with affected water wells could share a portion of the rents.  Due to the transmissivity created by fracking, review of common-pool issues is already done.  Expanding the unit considerations to include adverse environmental impacts as well as access to neighboring minerals is a possibility in light of recent findings without duplicating regulatory oversight.  Zeik (2010) discusses legal conflicts associated with subsurface trespass due to fracking.  Regulators already address these issues: environmental concerns are an extension into an additional resource realm.

Another regulatory remedy might be to create units, but unitization itself is fraught with contractual problems (Libecap and Wiggins, 1985; Wiggins and Libecap, 1985) of its own.  Adding an additional resource to the negotiations may further balkanize the parties (Libecap and Smith, 1999).  In such a case forced pooling may be the second-best recourse despite its evident shortcomings.  Forced pooling may be unpopular where surface ownership is highly fragmented, as some owners uninterested in nearby development are coerced into pools.  Resulting royalty payments might assuage some concerns, and information could flow more freely within a pool.

Short of full-blown unitization, many fields are subject to well-spacing regulations.  In the event that fractured wells create spatial effects at a different scale, well spacing regulations could be adjusted (up or down).  In order to do so, the existing review process need only be provided with more concrete information about the effects of fracking.  The cost of adjusting well spacing comes in the form of resource left in unextracted.

One final advantage of the existing structure is the opportunity for regulatory federalism, or experimentation with alternative regulatory regimes on a local basis.  This process offers more prospects for experimentation and adaptation to local conditions than presumptive top-down regulation from the federal level.  The increased initiative by states to require disclosure of fracking fluid chemicals is one example of marginal adjustment to existing regulatory frameworks.  This possibility of preemptive regulation or self-monitoring in a concentrated industry is appealing, though economists are always wary of regulatory capture.

Discussion

Although the policy recommendations in Jackson et al. (2011) and Osborn et al. (2011) are tempered, it is entirely probable that others will use their results to call for tighter regulation of hydraulic fracturing.  That may prove optimal.  However, a thorough understanding of the institutional environment in which fracking proceeds is needed before new regulations are promulgated.  Alternative allocations of property rights, contracts in place between the mineral and surface owners and operators, and the regulatory environment are all existing features that can be adjusted to accommodate new information about impacts of fracking.

A return to an earlier technology that was less productive and potentially more environmentally harmful is even less appealing than fracking.  In 1969, a 43 kiloton nuclear bomb was detonated underground near Rulison, Colorado in an attempt to free trapped natural gas.  The explosion was not successful in freeing large amounts of gas and the area remains off-limits to drilling today due to radioactivity concerns.  Another failed experiment in Rio Blanco County, Colorado led energy firms to experiment with hydraulic fracturing.  It is no coincidence that some of the advances made in fracking were made in the same area of Colorado.

References

Daintith, Terrence (2010) Finders Keepers?  How the Law of Capture Shaped the World Oil Industry.  Resources for the Future.

Howarth, Robert W., Renee Santoro, and Anthony Ingraffea. (2011)  “Methane and the greenhouse-gas footprint of natural gas from shale formations.”  Climatic Change. 1-12.

Jackson, Robert B., Brooks Rainey Pearson, Stephen G. Osborn, Nathaniel R. Warner, and Avner Vengosh (2011) Research and Policy Recommendations for Hydraulic Fracturing and Shale‐Gas Extraction.  Working paper, Nicholas School, Duke University.

Libecap, G. D. and S. N. Wiggins (1985) “The Influence of Private Contractual Failure on Regulation: The Case of Oil Field Unitization.” Journal of Political Economy 93(4): 690-714.

Libecap, G.D. and J.L. Smith (1999) “The self-enforcing provisions of oil and gas unit operating agreements: theory and evidence.”  Journal of Law, Economics, and Organization  15(2): 526-548.

Osborn, S.G., A. Vengosh, N.R. Warner, and R.B. Jackson (2011)  “Methane contamination of drinking water accompanying gas-well drilling and hydraulic fracturing. ”  Proceedings of the National Academy of Sciences 108(20): 8172.

Wiggins, Steven N. and Gary D. Libecap (1985)  “Oil Field Unitization: Contractual Failure in the Presence of Imperfect Information.”  American Economic Review  75 (3): 368-385.

Zeik, T. (2010) “Hydraulic Fracturing Goes To Court: How Texas Jurisprudence on Subsurface Trespass Will Influence West Virginia Oil and Gas Law.” West Virginia Law Review 112: 599.

 


[1] In this regard it is important to note that fracking is also used in petroleum production. The largest new oil field in the U.S., the Williston Basin, is heavily dependent on fracking for production.

[2] Cleaner is meant from the point of view of carbon emissions.  However, see Howarth et al. (2011) for a discussion of life cycle impacts of shale gas development (for which fracking is essential) as compared to conventional natural gas.

[3] EPA has documented the Pavillion and Clark, WY episodes.

[4] Dimock, PA is a well-documented but unverified example.

[5] Although structural estimates will have to wait until physical scientists can identify the causal links, this does not preclude reduced form empirical work in the interim.

[6] The number of affected neighbors can be approximated by , where d is the average distance of effects, p is the average parcel size, and α is a conversion factor. Increasing d has a similar effect to decreasing p.

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