The paper boom in shale gas: Why it shows the need for a functioning government
The New York Times just had an article about how insiders in the natural gas industry are concerned that the reserve and production estimates for recent shale gas discoveries have been significantly overestimated. The article states
“Money is pouring in” from investors even though shale gas is “inherently unprofitable,” an analyst from PNC Wealth Management, an investment company, wrote to a contractor in a February e-mail. “Reminds you of dot-coms.”
That development in itself is interesting, because the speculation in the industry in the past couple of years is that shale gas made available through fracking would enable a new era of cheap and abundant natural gas for the US. Some of that speculation is turning out to be hype, although there’s likely some truth in it also.
These developments point to a deeper issue, however: that of corporate governance and the government’s role in preserving the integrity of the market system. Two days ago, the New York Times reported that the SEC changed the reporting rules a few years ago so that natural gas companies drilling for shale gas could be more aggressive in how they booked reserves. As the article states
“In 2008, the stocks of many natural gas companies were sinking because of the financial meltdown, recession fears and falling gas prices.
But they began to rebound after a sweeping rule change by the Securities and Exchange Commission, intended to modernize how energy companies report their gas reserves.
As part of that change, the commission acquiesced to industry pressure by giving these companies greater latitude in how they estimated reserves in areas that were not yet drilled. The new rules, which were several years in the making, were officially adopted only weeks before the S.E.C. chairman under President George W. Bush, Christopher Cox, stepped down.”
The importance of this rule change cannot be overstated. Estimating the size of projected reserves is hard even with well understood technology. Doing it with a new technology like fracking is much more difficult. Erring on the high side (as the SEC appears to have done in this case) can create bubbles and hurt investors. Erring on the low side would make it harder for the companies to get capital, hurting investors in those companies and perhaps restricting the rate at which promising reserves could be tapped.
I think there’s a good argument for being conservative in such situations (i.e., erring on the low side): eventually reality will intervene, and if reserves are artificially overstated, then the correction, when it comes, will be sharp and painful. On the other hand, if reserves are understated, eventually it will become clear that the proven reserves are higher than initially expected, and that adjustment can be made with fuller knowledge. The investors in those reserves would be duly rewarded for their foresight.
Finally, this example shows the importance of having a functioning government regulatory system. Markets are human constructs and they can be made and operated well or poorly (for examples, see the terrific book McMillan, John. 2003. Reinventing the Bazaar: A Natural History of Markets. New York, NY: W.W. Norton & Company. ). If the regulators create rules not based on reality to favor certain industries, then disaster will eventually ensue, but the disaster doesn’t just hurt the company making the decisions, it also hurts investors who are misled by the incorrect claims of high reserves. That’s why the public interest demands regulation of markets so that the investing public has full and accurate knowledge about the claims companies make (that’s true also for consumer and food safety, as well as environmental issues).
The rules about such reporting play a critical role in ensuring accurate information, and they should be as reality based as we can make them. Too often that has not been the case. It’s true for the specific example of shale gas, but it’s also clearly true for financial markets, as Adam Smith pointed out more than 200 years ago. Having weak, ineffective, and feckless regulation hurts the market, and sensible folks ought to fight for reality-based regulation. Markets can’t survive long without it.
