Shale Gas: Opportunities and Risks

Nearly everybody in Poland considers exploring shale gas as a great opportunity for the country. The examples of Norway and Canada are often evoked as countries where exploration and production of hydrocarbons has proved successful and became an essential source of wealth. But the public is not aware of what Juan Pablo Perez Alfonso, the Venezuelan Minister of Mines and Hydrocarbons and cofounder of OPEC once said: “Ten years, twenty years from now, you will see, oil will bring us ruin” and even called oil “the devil’s excrement”. In his time Venezuela was a democratic country with the biggest GDP per capita in Latin America. It is now a ruin that has forgotten its best times.

This situation in Venezuela is not exceptional among countries that produce oil and conventional gas. To the contrary, according to 1995 research of Jeffrey Sachs and Andrew Warner, it is virtually the rule. The exceptions are Norway and Canada.

The biggest oil and gas companies, like the giant enterprises that explore shale gas in Poland, try to keep a low profile. At the same time their revenues, profit and general budgets are bigger than those of most countries around the globe. These companies have a very sophisticated international policy: recruiting among former diplomats and local state officials. Thus, without the robust security mechanisms in the state, the bigger oil production, the more influence the oil branch has.

Norwegian and Canadian success is based on their strong authority and internal cohesion. Moreover, these countries did not hesitate to clash with the companies in defense of national interests. Unfortunately, knowing the history of project management in Poland—with the recent highway construction as an example— it is difficult to be optimistic. The Polish state does not control situations where big business is involved and national welfare falls prey to private business groups. In the case of shale gas exploration it is mostly self-evident. Just like oil proved to be “the devil’s excrement” in many countries, there is a widespread concern that shale gas in Poland will turn out to be “an intestinal wind”.

Wrongly accredited licenses

Surely everyone who had worked on large projects professionally or privately (i.e. building a house) knows the effect, that may be called “the wrong button effect”. If you start to button a shirt with the wrong button, sooner or later a fold appears and the shirt is improperly buttoned. It is therefore essential how the project is designed and how it is initiated. Naturally, correcting buttons differs from correcting defectively constructed housing foundations. The latter resembles the situation of the shale gas exploration.

All the licenses in Poland were accredited on the general rule of “first come, first served”, neglecting not only free market principles but also common sense. The licenses are beneficial and the companies’ liabilities minimal. Some of the licenses were accredited to firms that were not capable of developing them, due to the lack of adequate know-how (which means they will only speculate on their position). One license is generally controlled by one company and the state has no impact on the selection of its possible partners (i.e. co-concessionary).

In Norway the procedure is different. Licenses are accredited in an open tender, however, the companies that partake in it are supposed to demonstrate adequate knowhow. The main criterion in the tender is the activity plan which suits the needs of the state. A single company cannot acquire a license; it is accredited to a consortium, with the public company Petoro as a passive shareholder. This is designed to ensure that the state controls investment costs and resource trade once gas is produced.

The first results of license accreditation in Poland are already visible. At the beginning of this year the milieu of shale gas explorers was shaken by a bribery scandal. Corruption mechanisms are systemic, hence it may be alleged that many, if not every, license was accredited wrongfully. Such a situation increases the long-term “above-ground-risks” of shale gas exploration and results in decreasing state capability to profit from relevant taxes.

The need for a strong state

High taxation of hydrocarbon and other resource production, paradoxically, is truly beneficial for private companies. States that impose low taxes on shale gas production are capable of activities that are not necessarily favorable for the companies (as their tax reliance is low). In that case, companies often engage in lobbying which boosts the risk of corruption. Nevertheless, the “above-ground‑risks” ratio increases. High taxation of hydrocarbon production, however, subordinates the state to those revenues and necessitates more concern for the whole branch, reducing its long-term risks. The state is virtually taken hostage by the industry.

Those who best understood that mechanism were the Norwegians. Business operation in their country is risky and difficult, with tax from profiting on hydrocarbons reaching 78%. Nevertheless, stability and state involvement, along with a prosperous service sector, are some reasons why companies are reconciled to a lower profit ratio in comparison to that obtained in other countries.

The service sector is essential. It is too early to state whether the profitability of shale gas production would be bigger or smaller in Poland in comparison to the US. Nonetheless, intense research and development of processes will be indispensable in order to develop the most effective technologies and shale gas exploration methods in Poland.

This is not an unprecedented situation. When Norway started exploration and production of hydrocarbons in the sea in the 1970’s, the technologies and methods were not adjusted for the conditions of the North Sea, the Norwegian Sea and Barents Sea. So Norway settled on support for research and developmental activities in the country and, furthermore, required that the companies did also. Consequently, it evolved into a technological and service hub for the industry, providing methods for hydrocarbon exploration and production in complex sea conditions.

If Poland draws conclusion from the Norwegian experience, it has an opportunity to become a similar research and development center in the shale gas/oil exploration and production field. It would have an enormously positive impact on not only the advancement of research and innovative technologies along with their proper commercialization, but also on the development of the local service sector. This sector drives Norwegian technology exports and related services and boosts employment. This prosperous sector generates a so-called multiplier effect in the economy. For every billion zloty of resource production there may be 5 to 10 times that amount in the economy, if it is spent in Poland, ensuring employment and investment capital in the country.

Regrettably, research is held in other countries and the service sector in Poland is slowly being dominated by foreign companies.

Four tips

The Polish government should courageously reform its entire management of the exploration and production of shale gas.

First, it should retrospectively elaborate and establish principles that should have been valid from the beginning. The restructuring of licensing, with the removal and nationalization of companies is nothing new for the industry. It would therefore be nothing unexpected among enterprises operating in Poland.

Secondly, it should introduce a rule that a national entity, equivalent to Norwegian Petoro, becomes a shareholder in all companies in question. Such an entity would partake in all the licenses and would supervise the cost policy of all the enterprises in all fields. A prospect of direct control of costs borne by private companies, i.e. establishing of reference costs, would enable a tax system to be based on the profit taxation rule. That would avert a natural tendency to company management founded on cost inflation.

Moreover, all the research and development related to shale gas exploration and production in Poland, as well as their commercialization, must be held on the spot. The companies involved would nevertheless have the possibility to write off even more than 100% (e.g. 130%) of the costs of these operations for many years. It was exactly what the Norwegian policy was that led them to their gigantic technological success in ocean based oil and gas exploration. Poland is poised to develop into the global research-development center of shale gas exploration and production.

Last but not least, all the companies that operate in Poland should contract other firms in open public tenders. It would occasion a dynamic development of small and medium enterprises and have a decisive impact on economic development. All the contracts must be as small as possible, e.g. “overall service” contract should be divided into small pieces so that they could be economically sustained, with all the pieces being subjected to the tender. Barriers to market entry would then be lower. Such rules of operation would not only generate high competition and activity on the market, but also facilitate innovation, since it is small and medium enterprises and start-ups that are often the most innovative.

In the short term, the above-mentioned rules may appear strenuous for companies, but in the medium and long term perspective they are indeed beneficial. They would help build a competitive market of service providers, reduce operational costs and minimize “aboveground- risks”.

Profit for the industry must be factored into the public policy. Otherwise every step forward to the development of shale gas production would lead Poland not to the Norwegian path, but to that of countries in which oil proved to be “the devil’s excrement”. As the global experience indicates, companies will always manage at the cost of society. A troublesome breeze is already blowing through the country.