Fracking and Finance

In 2008, the United States produced 18 trillion cubic feet of natural gas. Just over ten years later, this had grown to 34 trillion cubic feet. An even more spectacular rise took place in oil production over those years. Much of this growth was the result of new production techniques, namely hydraulic fracturing, that made previously unappealing sources of oil and gas profitable to develop. One firm in particular drove the change and it was neither an industry titan nor a nimble startup. Rather, the new techniques found their most remarkable and transformative success at a financially pressed mid-sized firm under pressure from market conditions, its lenders, and its investors.

Mitchell Energy

It wasn’t at the Mitchell Energy & Development Corporation where hydraulic fracturing was born but it was one of the first companies to deploy the strategy successfully and it did so where others saw little promise. Mitchell Energy was, for most of its history, active in both energy and real estate development. The company, founded by George Mitchell, a veteran of the Second World War and an oil wildcatter, operated a large Texas natural gas field called Boonsville Bend. Another prized asset allowed it to sell this gas at above market rates, a lucrative contract to supply natural gas to Chicago through the Natural Gas Pipeline Company of America (NGPL) from the late 1950s on. Through the NGPL contract, the company supplied 10% of Chicago’s gas consumption.

The company sold stock in its 1972 initial public offering, raising capital just before the Arab oil embargo lifted energy prices and Mitchell Energy shares. However, by the late-1980s, the initial heyday had passed and the company was in the doldrums. Financial difficulties mounted after oil prices slid in the early to mid-1980s and prices wouldn’t recover back to 1980 levels until the 2000s. Natural gas prices, more relevant to the company, also fell and its massive real estate project, The Woodlands, just north of Houston was also losing money. The planned community, meticulously designed by George Mitchell himself, housed Mitchell Energy’s headquarters and consumed large amounts of capital to build.

George Mitchell, Founder and CEO of the Mitchell Energy & Development Corporation

Finance

Long before any of these troubles arose, George Mitchell got his entrepreneurial start in the industry by dividing up leaseholds among Houston investors. Along with his older brother Johnny, he would study well logs to find promising sites and use the information to rally investors looking to grow their riches in search of oil and gas. George and Johnny Mitchell would sell these investments for a one-32nd or a one-16th carried interest, a share of the profits without having to invest any money themselves. Despite studying petroleum engineering and geology, Mitchell’s start in the industry was on the investment side.

Feeling more confident about finding natural gas in a particular region, Mitchell began to lease acreage in the Boonsville Bend field during the 1950s. Oil producers had largely ignored the area, finding it unlikely to contain appreciable quantities of oil. Looking for natural gas instead, Mitchell went all in, leasing 300,000 acres. It was a mammoth bet compared to his earlier small deals pitched to individual investors in Houston. To develop the field, Mitchell turned to an institution for debt capital, the Bank of the Southwest. Through the bank, he succeeded in getting a loan before any oil or gas had been pulled from the field, a rare feat. It may have made a difference that an energy banker at Southwest was his former professor at Texas A&M University.

A larger Mitchell Energy was later a client of Chase Manhattan but the bank was increasingly unwilling to allow the company to borrow more to fund its Boonsville Bend project. Rather than accept his lender’s constraints, George Mitchell decided to drop the bank. David Rockefeller, the heir to the Rockefeller oil fortune and then chairman of Chase Manhattan, tried personally to keep Mitchell’s business but was unsuccessful. It was a bold time to walk away from one’s lenders. In the 1970s, projections showed that the company’s premier asset, Boonsville Bend, would start to see dwindling production and evaporating profitability. This would make fulfilling the terms of the NGPL contract more difficult.

The threats didn’t end there. The 1980s saw falling energy prices and in the 1990s, lawsuits related to claims of contaminated drinking water resulted in a $200 million legal judgement against Mitchell Energy, which then had a market value of less than $900 million. The judgement was later overturned but not before the company had to secure a $250-million letter-of-credit provided by a syndicate of banks including Manufacturers Hanover and Bank One, which acquired Bank of the Southwest and with it the Mitchell Energy account in 1990. As with other firms in the capital-intensive oil and gas business, lenders were critical to Mitchell Energy’s survival and success from the beginning and thereafter.

Fracking

The 1980s and 1990s brought challenges; George Mitchell and his company looked for new sources of natural gas around the country but saw little promise in any of them. This was a period when many oil companies were writing off the possibility of large untapped fields in the contiguous Unites States. However, a growing body of research suggested there was one option close to home. The gas Mitchell Energy pulled out of the ground right at Boonsville Bend sat in porous reservoirs about 3,500 feet below the surface, but even further below that was a layer of rock called the Barnett Shale. Some believed it might contain even more natural gas.

That shale contained natural gas was not quite new information but fracturing the rock to release worthwhile amounts of gas would be a tough and novel challenge. Hydraulic fracturing, or ‘fracking’, presented a solution and had been used in the oil and gas industry for decades by this point. However, using it to break apart rock as hard as the Barnett Shale was not something that had been done successfully before. If it could be done though, it would unlock new sources of natural gas and maybe even oil.

For fifteen years, none of them particularly prosperous, Mitchell Energy persistently tried fracking in the Barnett Shale. Results were poor, at least in economic terms, as the process was costly relative to other extraction techniques. It was exactly for this reason that other large oil and gas firms were shifting investment in exploration and production overseas in search of new geographies in which to apply conventional drilling techniques rather than pushing the limits of domestic technology and technique. By the late 1990s, energy prices were still low enough that the sort of costs borne by Mitchell Energy were difficult to justify, and they continued to sink lower, boosting the anxiety of energy sector lenders and investors alike. Oil fell from $19 a barrel in the autumn of 1997 to under $12 a year later and Mitchell Energy shares halved.

The company had spent $250 million in the effort to extract natural gas from the Barnett Shale through fracking and had little to show for it. At least its development at The Woodlands produced some fine buildings. That said, some of the drilling cost was paid for by Department of Energy subsidies that covered half the cost of expensive fracking projects, a program intended to incentivize new exploration in the United States.

Nonetheless, the company’s management, its lenders, its investors, and its board agreed, costs had to be cut. Mitchell Energy finally decided whether it would be an energy or real estate company and The Woodlands was sold for $460 million net of taxes to a consortium that included Morgan Stanley. Further, Nick Steinsberger, an engineer at the company, led efforts to cut costs by applying new fracking techniques.

Steinsberger first experimented with forgoing special gels that acted as lubricants in the fracking process, instead relying on water alone, saving perhaps $200,000 per fracturing that might otherwise run up to a $700,000 cost. He also tweaked the volumes of sand used to keep open fissures in the fractured rock, but neither of these approaches increased the volumes of natural gas extracted. In the end, this was a volume problem, not a cost or financing problem. A breakthrough soon came in 1997 and 1998 though. In one experimental well, named S. H. Griffin Estate 4, the engineer changed the pace with which sand was added to the fracking mix, starting with little and gradually increasing. The output from that well was extraordinary.

After more than forty years at Boonsville Bend and after fifteen years of giving hydraulic fracking a try, Mitchell Energy had finally unlocked gas in the Barnett Shale, and in significant quantities. The company’s production soared and S. H. Griffin Estate 4 itself continued producing for two decades. That single well pulled out 1.5 million cubic feet of gas a day at the start and production continued for years. Having cost perhaps $700,000 to develop, that single well produced $8 million worth of natural gas in its life. It would soon be copied elsewhere.

Boom

With Steinsberger’s adjustments, hydraulic fracturing had become commercially successful in extracting gas from shale formations. From here, the practice spread to change the energy business, especially when it began being widely applied to crude oil after 2008. In Texas and elsewhere in the U.S., demand for promising oil and gas acreage soared. Previously rejected sites warranted reexamination and the potential of even the sure bets rose. Consider that in the early 1950s, Mitchell was leasing land for $3 an acre. Now, lease signing bonuses alone had grown to as much as $30,000 an acre, increasing the capital needs of exploration and production companies and busying the desks of energy bankers.

Lesson

Innovations in finance have frequently been wrought from necessity – from dire circumstances. During a prolonged era of low energy prices and dwindling American production, the energy business was transformed, at least in part because of financial necessity. The experiments Steinsberger and Mitchell Energy were conducting were not exactly spontaneous. They were calculated bets in the face of difficult conditions and limited resources in search of a specific result. Like virtually all great oil and gas finds, they are financial triumphs as much as geological discoveries or engineering achievements. Because of this potential for success, the energy business, one of the most volatile around, has always attracted investors and lenders of the sort that enabled Mitchell Energy’s formation, survival, and success.

More from the Tontine Coffee-House

Read about other financial impacts of energy booms and busts, including how surging oil prices in the late 1970s helped inflate a massive bubble in Kuwait and how falling oil prices a few years later helped end the Cold War.