Hydraulic Fracturing: Success and Failures of American Capitalism

7/28/2019 Hydraulic Fracturing: Success and Failures of American Capitalism

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Hydraulic!Fracturing:!!

The!Success!and!Failures!of!!American!Capitalism!

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Spring!Semester!2013!

Cody!Moreland!

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The Success and Failures of

American Capitalism____________________________

Recommendations to the Nation for Regulating

and Enabling Hydraulic Fracturing

Name: Cody Moreland

Date: May 2, 2013

Class: POSC 4341Instructor: Dr. Prout


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Table of Contents

2 Introduction

3 Economist Perspectives

4 Adam Smith

4 Joseph Schumpeter

5 Todays Economy

6 Government Enabling Business

7 Government Regulating Business

9 Fracking/Oil Production

9 Oil Industry History

11 Why we need Energy Independence

12 Fracking Boom or Bust?

13 Environment

15 Sustainable Production

17 Moving Forward - Recommendations

20 Conclusion


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Introduction

In every economy, companies bring together resources, labor, and

technology to produce and distribute goods to consumers. The way these

different components of an economy are structured and used, also mirrors a

countries political ideologies and culture. In America we are considered to

have a culture of capitalism. Our economy is considered a "mixed", because

the government plays a significant role along side the private sector. In this

capitalist system the central component is the market, which is regulated and

protected by the government. The market helps allocate scarce resources and

allows people to create value. Without the ability to grow value by risking

capital, the real engine of capitalism grinds to a halt.

American politics has long debated the role the government should

play when it comes to regulating and enabling our economy. We have

entered an age where the need to find the perfect the role of government is

essential to our prosperity, because the global economy we have today is not

immune to crisis. We are now faced with the question of whether it is more

efficient to move away from the individual capitalist system we have today,

or if we should incorporate a state-capitalism system like the BRICS. It is a

rather complex question, and before it can be answered we must analyze

whether our current brand of American capitalism in itself has been a


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success, or failure. In regards to the success, and failures of American

capitalism this report will review whether government intervention has

helped or hurt the economy.

Over the course of our history the government didnt create the most

powerful economy in the world through extensive regulation, however,

government policies that enabled our businesses to grow and citizens

prosper, did create our status of economic superpower. With that being said,

the mixed economy we have today will not last forever if our governments

inefficiencies in market intervention continue. Going forward we need to

have a pro growth agenda that allows sustainable outcomes. This can be

achieved if the government strikes a healthy balance between regulating

business on one hand, and enabling business on the other. This balance can

be achieved by weighing the negative and positive externalities of enabling

and regulating capitalism.


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Economist Perspectives

In America, we now see two dividing ideologies when it comes to the role of

government intervention in the market. On one side we have Jeffersonian principles,

which argue the government intervention has not been main reason of our successes. And

on the other side we have those with Hamiltonian principles that argue the contrary,

saying that strong national government has been the constant enabler of our growth

since the founding.

Before there was government, man was born free, but was everywhere in chains.

During this time everyone had unlimited natural freedoms, including the "right to all

things" and thus the freedom of no regulation. This led to an endless "war of all against

all". In the state of nature there were no social goods such as education, technology or

industry, because the social cooperation needed to produce them did not exist. To avoid

the state of nature, savage men contracted with each other to establish a civil society

through a social contract in which they all gained security in return for subjecting

themselves to a government. When man entered the social contact he gave up his

personal economic freedoms of no government intervention, however, the contract

allowed for government to enable and regulate the social goods of society at a sustainable

level, which in return helped man and society develop. We have seen the tension between

economic freedom and the broader welfare of the community arise from the social

contract and still define the relationship between our government and business today.

Adam Smith

Adam Smith also subscribed to this prevailing Enlightenment notion of natural

rights and then looked to define what the social contract meant for the relationship


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between government and the individual. While Smith argued for a minimalist

government role, and believed the multitude of exchanges and transactions were indeed

governed by an invisible hand. Smith also understood that men have always been self-

interested and since man is self-interested, he will tend to create externalities in the

market and may indeed need regulation. He did however, also suggest that man may feel

sympathy for his fellow man, and indeed would often act in accordance with how an

impartial spectator might view himself. Smiths Theory of Moral Sentiments thus laid

important groundwork for ensuring that capitalism would not ignore its externalities.

Joseph Schumpeter

While Smith argued that domestic markets were robust and thus inclined to grow

on their own without government intervention, another economist, Joseph Schumpeter

held a similar view, in that the free flow of capital to investments, that can either succeed

or fail, leads to a creative destruction, or constant reinvention of an innovation fueled

economy [1]. Schumpeter believed capitalism could only be understood as an

evolutionary process of continuous innovation and 'creative destruction'. Currently, we

are witnessing our own creative destruction with the drilling technology of the oil and

natural gas industry. We now have the reinvention that Schumpeter said would fuel our

innovation-based economy. The reinvention of technology is with hydraulic fracturing,

which has allowed companies to reach and extract shale oil that was once deemed

inaccessible.

The way the government regulates and enables this new technology will be a

momentous policy decision going forward. The government needs to be efficient,

because as Schumpeter argued, government creates scarcity. He also believed that when


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consumers want more of something, businesses will find ways to fuel the demand. In the

mid 2000s, we saw an example of this consumer-business relationship when the global

demand for oil increased and caused domestic oil prices to rise drastically. To combat the

rising prices and increased consumer demand, innovators reinvented the hydraulic

fracturing technology, allowing them access to shale oil that was once deemed

unreachable, as well as allowing them to supply the increasing demand. This, as

Schumpeter would agree, is the new technology that will fuel the worlds capitalist

growth in the area of energy consumption. This technology, if handled properly through

efficient government enabling and regulating, may allow us to achieve the goal of energy

independence by 2030.

Todays Economy

Today there are two distinct views of how the government and the economys

relationship should work. One theory is that a good economy is one in which the

government enables business. Its a system where businesses establish a partnership with

the government that enables them to grow. This view believes the government should not

intervene or intrude upon the businesses economic freedoms, but instead should enable

them to grow and be competitive.

The second theory believes that a good economy is one in which the government

regulates businesses. Those who follow this theory believe that society should worry

about the collective wellbeing. Most members of this ideology view this as not only a

good moral view, but also as a path for future sustainability.

Currently, we are facing an inescapable dilemma in regards to global capitalism.

As the global population continues to grow rapidly and developing nations continue to


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modernize, energy consumption around the world will also continue to rise at a

staggering pace. The International Energy Agency predicts a 70 percent increase in

global energy use by 2050 [32]. Will the increase in global demand for energy cause us to

sacrifice our economic freedoms for the collective well-being? With a large amount of

nations developing, we could, in just few decades see the use of our fossil fuels begin to

severely affect the earth's climate and our daily lives. It is clear we now live in a world of

global imbalances. Sustainability, or the capacity to endure, will require us to meets the

needs of the present without compromising the ability of future generations to meet their

own needs. Sustainability may not be the most desired political issue, but achieving it has

become one of the greatest challenges to capitalisms survival. To ensure sustainable

outcomes, the government will need to strike a healthy balance between regulator and

enabler.

Government Enabling Business

The government has always played a very big role in terms of enabling business

in American Capitalism. From Henry Clays American System that focused on a strong

national government, to the Homestead Act of 1862 that distributed 270,000,000 acres of

federal land for private ownership, then followed by the Minerals Depletion Allowance

of 1958 and the Telecommunications Act of 1996, the government has consistently

enabled American business by granting licenses, copyrights, and patents; issuing land and

low rents; and by providing subsidies. This challenges the view of Hayek and Friedman

that government should essentially stay out of the way of the market.

TheLaissez Faire, orfree marketsystem that Adam Smith was a proponent of

reemerged throughout the United States in the 1970s and 1980s [2]. During aLaissez


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Faire government, transactions between private parties are free from government

restrictions, tariffs, and subsidies, with only enough regulations to protect property rights

[3]. Most actions taken by government in a Laissez Faire system are not to constrain

business, but to enable its further development. Even those government actions aimed at

ending the dominance of the trust, such as the Sherman Anti-trust Act, were seldom

administered.

Government Regulating Business

In terms of regulating the market, the government has applied many regulations

over the course of our history to allow for our long-term growth rate to be sustainable. In

the 1819 case ofDartmouth v Woodwardthe court settledthe issue of private charters

[4]. As a result of the landmark case the American corporation and the free enterprise

system were born. From this point on in history American corporations enjoyed a

protected status and by the turn of the nineteenth century morphed into large vertically

and horizontally integrated trusts with massive economic and political power. Yet

beginning with the progressive reforms of Republican Teddy Roosevelts New

Nationalism through the New Deal and Great Society reforms, the latitude American

corporations could exercise in the marketplace was redefined.

While we often want the government to enable business, at times our country has

looked to the government to regulate companies that create market failures. We have seen

the government address market externalities that the free market economy overlooks,

such as the environmental concerns we see in our current debate over fracking. Even with

a strong sentiment for the free hand of the market, throughout our history we have still


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relied on the government to grow developing industries, and at times apply protectionist

measures for American industries, beginning with the Report on Manufactures in 1791.

During the remainder of the 20th century and now into the 21st, government

regulation of financial activity has exponentially increased. Yet with each successive

wave of regulation beginning with the New Deal and recently concluding with Dodd-

Frank, there seems to be no way to prevent white collar criminals and corporations from

finding new ways to bypass regulation and take advantage of innocent consumers with

financial activities such as derivatives. Whenever a regulation is created, there will

always be someone or some company trying to evade it. With the fracking example, we

have seen companies easily evade regulations. Since hydraulic fracturing typically

introduces a mixture of potentially toxic chemicals into the ground, it is supposed to be

regulated by the EPA under the Safe Drinking Water Act [5]. But due to another federal

law enacted in 2005, the EPA does not currently have the authority to regulate the

underground injection of chemicals during the hydraulic fracturing process.

This prohibition is a result of provisions within the 2005 National Energy Act,

which was enacted by Congress and signed into law by President George W. Bush. The

prohibition has been called the Halliburton Loophole, because it came from

recommendations made in 2001 by a Special Energy Policy Task Force headed by then

United States Vice President Richard B. Cheney, who had served as Chief Executive

Officer of the Halliburton Corporation, a leading energy company in Texas that initially

developed the modern hydraulic fracturing process [6]. Fracking companies evade

regulations by using this Halliburton Loopholewhich frees the fracking practice from

regulation of the EPA and allows them to circumvent the Safe Drinking Water Act.


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Also amended in the 2005 Energy Policy Act was the Clean Water Act. Congress

enacted the Clean Water Act back in 1972 as a way to regulate discharges into the

countrys rivers and streams [7]. The Clean Water Act was amended in 1987 to include

storm water run-off. But now oil and gas production are exempted from those

regulations. And in the 2005 Energy Policy Act, those exemptions included oil and gas

fracking sites [8]. Environmentalists have worried about run-off from well pads, pipelines

and construction sites. With all of these exemptions we see how part of federal

government wants to enable the fracking industry, while on the other hand part of the

government works to regulate the industry. Going forward we need to strike a healthy

balance between regulating and enabling the industry.

Fracking/Oil Production

History

The history of our oil industry started during the Gilded Age of American

industry, when John D. Rockefeller founded what was to become Standard Oil in 1860.

Rockefeller's innovative and competitive approach led Standard Oil to own upwards of

90 percent of the oil refining market but also dramatically lowered the price to consumers

from 58 cents to eight cents a gallon [9].

By the 1920s, oil prices had peaked causing many to believe that oil would soon

run out. This prompted Congress to put in place generous tax allowances for producers,

which prompted further investments and ultimately led to the discovery of large, new oil

reserves [10]. But then, with prices dropping, demands for price supports and restricted

competition emerged. Consequently, President Roosevelt, in 1933, created the

"Petroleum Code", allowing the government vast powers to fix prices, dictate wages and


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hours, limit production, and control the importation of oil. The Code enabled the

government, through local agencies, to restrict production. With production heavily

regulated, prices rose again [11].

Meanwhile, oil production elsewhere, particularly in the Middle East, took off. A

combination of high demand and rising domestic oil costs ushered in a willingness to

purchase oil from outside the United States: In 1948 the U.S. officially became a net

importer of oil [12]. As imports of lower cost oil surged, domestic producers lobbied

Congress to impose oil import quotas, which President Dwight Eisenhower established in

1959 [13]. The government quotas dictated how much crude oil and refined products

would gain entry into the country and gave preference to imports from Canada and

Mexico.

Excluding the oil producing states of the Persian Gulf from a free market

exchange depressed Middle Eastern oil prices. As a response to the U.S. import

regulation, four Persian Gulf countriesIran, Iraq, Kuwait, and Saudi Arabiaalong

with Venezuela, founded the Organization of Petroleum Exporting Countries (OPEC) in

1960. In 1973 the world experienced an oil crisis when OPEC caused a sharp increase in

oil prices by reducing the crude oil output in order to raise profits. In essence, this has

been OPEC's agenda ever since [14].

Why We Need Energy Independence

Today, the same concerns we faced in the Gilded Age over the role oil should

play in the U.S. economy continue. The Left focuses mainly on the environmental

consequences of abundant use of and continued demand for oil, the rising profits from oil

to producers, the role of speculators, and the price increases to consumers. The Right


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warns of the security risk associated with purchasing oil from politically unstable or

outright hostile regimes and thus pushes for relaxation of domestic drilling restrictions.

Both views assert that oil's heyday as a cheap and plentiful fuel has ended, as the

earth's natural oil supply is running out and rising economies across the world ramp up

their oil demands. As developing nations of the world are seeing huge increases in energy

consumption, the rate of global capitalism also continues to rise. The needed global spare

capacity, which is a safeguard supply against oil market disruptions, could continue to

rise sharply alongside the devolving world and exceed 8 million barrels by 2030 based on

EIA estimates. The current global share capacity as of 2013 is 2.4 mbd [15]. This huge

gap in the global share capacity illustrates how the increasing demand will affect our

future. This gap also provides our business and government with an adequate reason to

develop our fracking technology, increase oil/gas production, and become energy

independent.

Going forward, we need to become energy independent so that a disruption in the

supply wont force us rely on spare capacity, because doing so could have devastating

effects to our own economy. We saw how close we can come to a disruption in the

supply when Iran threated to close the Strait of Hormuz, which is the most strategic oil

choke point in the world. Our dependence on volatile foreign oil market has been the

thorn in our side since we became a net importer in 1948. Unless the U.S. gains a large

share of the oil market, OPEC will continue to have the ability to increase prices and

control the flow of oil at the tip of their fingers. As of now there is no global spare supply

outside that of the OPECs, however, there is a strong possibility that if the U.S.

government enables oil and natural gas production, it would allow the industry to grow


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and would cause OPEC to lose price control. By allowing crude oil prices to collapse, it

would cause a major blow to the political power of OPEC. It will remain an important

strategy to take energy independence seriously, because if we fail to do so it will have

devastating effects to our national, human, and economic security going forward.

Fracking Boom or Bust

In the last five years the United States has seen a boom in oil and natural gas

production. This boom has taken place because of technological advancements in the

fracking process and new government policies that focus on energy independence. The

path to energy independence allows the government to enable energy production through

various investments and policies. Over the next 15-20 years the DOE estimates that

demand for energy will rise sharply by almost 50 percentlargely in response to the

capitalist economic growth in the developing world [16]. To keep up with the rising

demand, the private sector and government will need to work together. On one hand,

energy companies will need to increase production efforts, and on the other hand

government will need to ensure the flow of oil to consumers. As Joseph Schumpeter

would agree, capitalism and economic growth caused by the developments in fracking

technology essentially benefit those at the bottom by providing them with goods and

services that they previously would not have been able to afford. And perhaps more

importantly, it does this without coercion, force, or central authority to direct it. There is

still much to learn form hydraulic fracturing, as it is still a rather new technology. There

is a learning curve for all new innovations as Schumpeter argued, and going forward we

must understand this concept with Fracking.


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While it is clear that government wants to enable the fracking industry, they also

have a compelling interest to regulate the environmental damages caused by fracking.

The regulation of businesses that harm the environment has been a rising trend in our

political system since the 1960s. This environmental regulation trend is a good example

of how government intervention can protect the future sustainability of capitalism. If the

government does not regulate the environment, capitalism will run its course and dry up

every resource the environment has to offer. Going forward, it is important that the

government has oversight over production levels so that it is done at a sustainable rate. A

sustainable long-term supply that can avoid price shocks and environmental damages will

be a vital aspect of our growth. There can be a mutually beneficial relationship between

the government and the oil/natural gas industry if the two sides work together. The next

two sections will evaluate the regulatory process on the environment in terms of fracking

and whether or not increasing production is sustainable policy.

Environment

Beginning in the late 1960s and early 1970s, the world, and specifically the U.S.

saw a growing trend in concerns for environmental issues caused by rapid industrial

growth [17]. The powerful social movement behind the trend argued that economic

growth caused environmental decline and could not be sustained forever. At the time

there was a vast amount of pollution from the increasing amount of cars, as well as from

the many companies who were dumping harmful waste. The pollution was creating what

we refer to as externality a cost the responsible party can escape, but that society as a

whole must bear. With the free market forces unable to correct these externalities, a large

amount of environmentalists argued that, the government has a moral obligation to


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protect the environment - even if doing so requires some economic growth to be

sacrificed [18]. A vast amount of new regulations were created by the government: from

the 1963 Clean Air Act, to the 1974 Safe Drinking Water Act, these regulations were all

designed to control the wide range of environmental damage.This current debate over fracking is an example of these long-standing tensions

between enabling business on one hand, and protecting the environment on the other. The

major obstacle that fracking will need to tackle if it wants to reach its full potential is the

public concern that it will negatively impact the environment through water

contamination, seismic inducement, and methane emissions [19]. The fear of

contamination of surface water and groundwater during operation and the risk to water

resources for all users in the area are the primary environmental concerns of government

regulators. Public concern over fracking rose dramatically after many environmental

experts argued that drinking water can be affected by the hydraulic fracturing process.

However, in response the EPA did extensive research on the effects fracking has on

drinking water. The results of their 2004 study showed no connection between

contaminated drinking water and fracking [20].

These are all examples of the long-standing tensions between the environmental

lobby, (which prefer more government regulation), and business (which prefer a more

enabling government approach), in terms of government intervention. It is clear that the

government and the fracking industry must work together going forward. Whether it is

from new technologies that allow them to increase their presence in the natural gas or oil

market, or whether government funded research allows the company to create new

technologies, the private sector and government must collectively work together to form


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a solution to fracking that poses less of a threat to the environment. Schumpeter would

agree, that innovation of the fracking process, by making it more environmental friendly,

is essential to fueling our capitalistic growth.

Sustainable Production

While the previous section viewed the environmental factors, this section will

view why how the government can enable the industry, but at the same time have

sustainable production rates. Increased production has its merits, but the government

needs to know the limitations of the market. We now know that there is enough

recoverable oil in the U.S. to last us the next 200 years [21], but instead of drilling

strategically we have tried to maximize profits without a long-term vision. You cannot

over saturate any market to quickly without causing a market imbalance in the supply.

The government regulators need to realize this market failure and improve regulations

that allow for sustainable outcomes. Gas producers have been able to take advantage of

the Halliburton loophole and drilled too many wells too quickly, which in turn caused the

price of gas to drop below the cost of production.

While many argue that the recent surge in production was originally driven by

new drilling technologies, many oil and natural gas companies argue it was due to the

high prices at the pumps, which reduced consumer confidence in the market. In the case

of oil and gas the demand for the goods had been increasing but the supply was

dwindling. With a limited future supply, the companies only way to make profits was by

driving down production costs and becoming more competitive. From the years 2005

through 2008, as conventional gas supplies dried up due to depletion, prices for natural


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gas soared to record highs - $13 per million BTU [22]. In the 1990s the price for natural

gas was around $2 per million BTU.

It was these record high prices that gave businesses an incentive to invest in

expensive new technologies that could access resources once thought of as unreachable.

For example, many oil companies flocked to the Haynesville shale formation in Texas,

bought up mineral rights, and drilled thousands of wells in short order [23]. Many of

these companies did not think of over producing because they were blinded by the

potential profits. High per-well decline rates and high production costs were masked by

the vast amount of new production. With companies having a surplus of supplies, gas

prices fell below $3 per million BTU, which was actually less than the cost of production

for most companies [24]. This dilemma forced U.S. oil and gas companies to find a way

to draw additional investment capital just to sustain their cash flows. The CEO of Exon

Mobil was quoted saying, We are all losing our shirts todaywere making no money.

Its all in the red. It was obvious that the gas producers drilled too many wells to quickly

and created a market imbalance. This is where government intervention in the market can

help businesses going forward, so that sustainable production rates are the norm and that

market imbalances are minimized.

Moving Forward- Recommendations

In the future, finding sustainable production rates and minimizing market

imbalances will call for government intervention in the market. While Joseph Schumpeter

argued government intervention in the market tends to slow down innovation and prevent

growth, I think he would also realize that an efficient government regulation could

actually create growth, as well as be protective of the collective good and private


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sector. An example, and possible recommendation for how the government can regulate

to create growth in fracking is by regulating the type of equipment they use. The

government can regulate the equipment and production process so that it is

environmental friendly, while at the same time enabling business through government

research. This regulation can clearly be balanced if the government enables business by

increasing funding in research of: efficient equipment, environmental friendly

production, and cost effective ways of fracking. This relationship between business and

government will be essential for our capitalist system going forward.

While the core of previous recommendation called for the government to regulate

equipment and the production process, I believe we can still create policies that

encourage production. As long as the production process meets the environmental and

sustainability requirements, the government can continue to enable the industry. If the

environmental standards trend becomes the new norm, then government should look to

incentivize companies for meeting these standards. Obviously these companies

currently do not follow all regulations, so incentivizing will help the private sector

become more efficient and eco-friendly. We want the industry to grow responsibly,

because it will benefit our economy in the long run by creating jobs and reducing

environmental damage. The U.S. will have enough natural gas and oil to meet the

domestic demand and generate potential global exports for the next century only if the

government continues enabling production at a sustainable rate. The sustainable rate has

been a core argument of this report because it is essential to our long-term growth. If we

do indeed increase production at a sustainable level, we will reduce our foreign oil


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imports and will cause a substantial reduction in the U.S. net trade balance, thus leading

to faster economic expansion.

Going forward, if the government can enable fracking, while at the same time

keep the environmental lobby happy, it would allow for bipartisan cooperation in

Congress. The goal of energy independence set in place by our last two presidents could

be momentous opportunity for bi-partisan support. The cooperation between both sides of

Congress on the issue would allow for other realms of politics to be handled bi-partisanly

and could eventually lift us from the political gridlock problem we see in American

capitalism today. This recommendation will not be an easy process, as both the

environmental lobby and oil lobby respectively hold a lot of congressional bargaining

power.

It is clear that, in order to achieve the goal of energy independence by 2030, the

government will need to invest more in the research of safer fracking methods that

guarantee protection of the environment. This research could be done through a race to

the top initiative, which would create more competition to innovate. The government can

help enable the competition needed to promote a sustainable and efficient growth rate.

In terms of production to achieve energy independence, the government can

intervene by allowing each company a certain percentage of wells, based of how well

they follow regulations. This is turn would force companies to comply with regulations.

While the government could also step aside and let the free hand of the market work itself

out, I would argue that intervening would allow for the distribution of resources to spread

out among the market. This would be a true way for the government to enable small

business, which is the backbone of the American economy.


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As you can see it is very easy for oil companies and the government to say, drill

baby drill, but as Adam Smith would agree, there will always be externalities, or loose

rocks that companies overlook as they climb the mountain of potential profits. This is the

defining reason why it is so important for the government to play an efficient role when

regulating oil and gas companies. While environmental regulation may in fact slow down

growth, it will remain an important factor for our long-term survival. If society keeps up

the tragedy of the commons strategy, we will eventually rid the entire earth of its

resources. Government after all is the main allocator of these scarce resources and if the

government can get those resources to the maximum amount of people at an affordable

cost, then society will become more efficient as a whole.

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Conclusion

Over the course of this report I have argued for increased efforts of

government-funded research in fracking that will allow the private sector to

take new technologies and develop them further into products for the

marketplace. Technology advancements can sufficiently boost economic

productivity to prevent a long-term slowdown. Going forward, this

prevention of a long-term slowdown will enable us to invent alternative fuel

sources such as water or algae that are easily renewable. A renewable energy

source will slow down the consumption of scare resources and allow society

to progress more rapidly. If we are to ever address serious issues like climate

change or other pressing environmental concerns, and, at the same time,

ensure energy access and security for the American people without

overburdening the U.S. economy, alternative sources of energy must be

developed, energy conservation must be encouraged, and advanced

technologies must be developed and deployed. I remain a strong believer

that the U.S. can see an economic turnaround due advancements in

technologies that enable our businesses to grow.


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Hydraulic Fracturing: Success and Failures of American Capitalism

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