In Milton Friedman’s classic TV series “Free to Choose”, the reoccurring theme was that economies thrive and grow when individuals are free to choose how to satisfy their wants, needs and desires. A great example of this phenomenon is occurring right now in the US, especially in states like Texas, North Dakota, Pennsylvania, West Virginia and eastern Ohio.
No government agency is controlling the price of hydrocarbons, and there is no direct subsidy for hydrocarbons. But companies are, nonetheless, figuring how to produce the right amount of the right product for the market while generating positive rates of return on investment. In fact, the rate of return on investment for drilling in the liquid-rich parts of the Marcellus Shale can be quite large (>100%/yr.) Note that this calculation can be found at the following site. Though, it should also be noted that, if you drill in an area low in higher hydrocarbons, you are likely to obtain a negative rate of return on investment because of the near historically low price of natural gas in inflation-adjusted dollars.
Given that it’s the natural gas liquids that determine the economic viability of drilling in the Marcellus and Utica shales, it’s important to give an overview of the technology behind separating natural gas liquids from the raw natural gas so that those people who are not familiar with the oil&gas industry can learn more about midstream operation, i.e. the steps taken after the gas has left the ground and before it’s in a condition to sell on the market.
The first step taken at nearly every wellhead is to remove room temperature liquids just as the gas leaves the ground. Water, surfactants and long-chain hydrocarbons, like heptane and octane, will condense out at room temperature. Most companies will try to skim the hydrocarbons from the surface of the water in order to sell these higher hydrocarbons to oil refineries. After this step, the gas is sent to a collection facility in the region via low pressure gas pipelines. The collection facility is typically called a compressor station. After increasing the pressure, various gases are removed from the raw natural gas. Depending on the raw gas composition, this might include removing acid gases (carbon dioxide and hydrogen sulfide) thought the use of basic (i.e. high pH) amines such as monoethanolamine (MEA) or through the use of physical solvents like Selexol. It might also include removing higher hydrocarbons, such as ethane, propane and butane.
There are two very different technologies for removing propane and butane from natural gas. The technique used most often in the Marcellus shale region is cryogenic separation. A series of compressors, heat exchangers and expanders are used to chill the gas to a temperature and pressure at which propane and butane will condense out of the gas phase. The largest separation company in the Marcellus Shale region is MarkWest L.P., and the predominant technique they use to separate out the higher hydrocarbons is cryogenic separation.
The other dominant technique in industry is selective adsorption, and one of the main companies that uses selective adsorption is Keyera, which is based in Alberta. Keyera’s website contains a wealth of educational videos on its midstream technologies, and I recommend watching these videos if you are interested in learning more about the steps taken to prepare raw natural gas for sale on the market. The concept behind selective separation is that a liquid is chosen for its capability to selectively adsorb the higher hydrocarbons. The gas and the liquid flow in opposite directions, in what is called a counter-current absorption tower. After adsorbing the higher hydrocarbons, either the liquid is heated or the pressure is dropped to the release the ethane/propane/butane.
In certain regions of the Marcellus and Utica shale, the raw gas composition can be: 74% methane, 15% ethane, 5% propane, 2% butane, 1% pentane, 1% hexane+, and ~2% CO2/N2. That’s a lot of higher hydrocarbons. In fact, on an energy basis, this gas is only ~50% methane. And because higher hydrocarbons have a higher sale price per BTU than methane, the sale of these higher carbons can be well over 50% of the revenue for drilling companies.
While there are two well-established means of removing higher hydrocarbons, this doesn’t mean that there aren’t better ways of removing higher hydrocarbons. Perhaps a new company can develop an even cheaper way of removing the hardest gas to remove (ethane). It will be important to develop better techniques for removing ethane from the gas in the Marcellus Shale because cryogenic separation of ethane from natural gas is quite energy intensive. The reason why the ethane has to be removed from natural gas in the Marcellus Shale region is that pipeline companies will not purchase natural gas from the compressor stations unless the ethane composition is below approximately 4%. There are strict regulations on the energy content of natural gas. So, if the raw gas contains 15% ethane, then there is a significant amount of ethane that needs to be removed.
But this is magic of the market. Companies like Shell see this potential glut of ethane as a potential source of revenue. Shell is planning on building an ethane cracker near Pittsburgh, PA in order to convert ethane into ethylene, which is the principle component in the plastic polyethylene. Shell does not need subsidies from the government to build this ethane cracker plant. Neither does MarkWest need subsidies from the government to build compressor stations in the Marcellus shale region. Shell, Range Resources, MarkWest, Exxon and all of the other companies in this region aren’t trying to save the world or to make as many jobs as possible. They are simply doing what they are supposed to be doing: obtaining a positive rate of return on work invested.
The magic of the market is that when we all individually try to maximize our own rate of return on work invested, we collectively generate a growing economy. Stated again, if we each focus on obtaining a positive rate of return on work invested, we’ll get both growth and jobs. But if we focus on creating jobs, we’ll get neither more jobs nor growth. And ultimately, the problem with government involvement in markets (other than to protect property rights) is that most governments are more interested in “creating jobs” than in obtaining a positive rate of return on work invested.
As one can see from the economic boom in places like Texas, Pennsylvania, and North Dakota, when a company focuses on the rate of return rather than focusing on jobs, we can get both jobs and growth. Further, it is the fact that oil&gas drilling has such high rates of return on investment (i.e. it only take a small amount of work to obtain fuels that can generate lots of work in vehicles or power plants) that both creates growth and allows for greater consumption of “luxuries.” When we find technologies with large, positive rates of return on work invested (such as natural gas drilling and natural gas combined cycle power plants), we can reinvest some of the profits back into growing the business, but we can also use some of the profits to purchase luxuries. In fact, the higher the rate of return on investment of an energy technology, the less people are required to be working in the energy field, which allows more people to be doctors, teachers, musicians, basketball players, astronauts, etc… The problem with government involvement in the energy sector is that most governments have historically subsidized energy technologies with low or negative unsubsidized rates of return on investment (wind, solar, and biofuels.) So, while the government involvement is really good at “creating jobs” in the short term, the overall effect of paying people to produce expensive electricity or fuels is that the overall economy will contract, more people will end up working in the field of energy development, and less people can afford to be musicians, poets, and scientists. The irony is that many musicians, poets, and scientists are against the high rate of return on investment technologies required for our society to support them. While individuals aren’t perfect at picking technologies with positive rates of return on investment, societies in which individuals are free to choose how to invest are historically better than societies in which the government decides when and how to invest.
So, for those of you who don’t work in the energy industry, my suggestion for how we can grow the economy is for more people to learn how to invest in energy-related mutual funds. Because of the extremely volatile nature of oil&gas drilling, I don’t suggest investing in individual companies. Let somebody who is knowledge in the oil/gas/electricity business make the day-to-day decisions of into which companies to invest. My suggestion is that you use the profits from investing in the energy industry to (a) reinvest back into energy investment funds, (b) invest in other parts of the economy, and (c) to purchase luxuries for you, your family and your friends. The important point is that we now live in a society in which nearly all wealth (i.e. electrical and mechanical work) is first generated in the energy industry. A wise investor first invests in energy funds/projects that can obtain high rates of return on investment, then uses the profits to diversify into other parts of the economy, and then finally purchases luxuries. We get into trouble as a society (Great Depression or the Great Recession) when we mistake luxuries (shorter work weeks, houses, college education, health care) for the underlying generator of wealth (power plants with large rates of return on work invested.) Luxuries are great, and we should be free to choose how much we each invest and how much we each spend on luxuries, but a wise investor knows that luxuries should only be purchased after having earned the money by investing, and not by taking out more and more debt.