On the Rise

• Author: Thomas Helbling
• Position: a Division Chief in the IMF's Research Department.

A strong rebound in gas and then oil production in the United States over the past few years has taken markets and policymakers by surprise (see Chart 1). As a result, natural gas prices in the United States are at a 20-year low after adjusting for inflation, while light sweet crude oil from the landlocked production areas in the U.S. Midwest is selling at an unusually large discount from international benchmark prices.Â

The surge in production is largely the result of the new ability of producers to extract oil and gas from unconventional geological formations—so-called shale rock and tight rock or sand formations. The revolution in production occurred first in natural gas and more recently in oil.Â

It is already widely accepted that the availability of shale gas resources has fundamentally changed the outlook for natural gas as a source of energy. Prospects for unconventional shale and tight oil production are more uncertain though. Could its development foreshadow a long-term decline in oil prices, as happened during the mid- to late 1970s after the 1973 Middle East war triggered a surge in oil production? Conversely, are there risks that the revolution will not last? Moreover, how will it alter the macroeconomic effects of sharp changes in oil prices (so-called oil shocks) on the U.S. and other economies?

Triggered by high prices

The sudden takeoff in the production of oil and gas from unconventional sources in recent years is another case in which high prices and new technologies combined to turn a previously uneconomical resource into an economically viable one. The jump in oil prices in late 1973, for example, made the development of new oil resources in the Arctic (Alaska) and the North Sea economical and eventually contributed to declines in oil prices that persisted well into the 1980s. More generally, the development of new sources of supply is a normal response to a commodity price boom and has historically been one of the forces behind price declines after a boom. The technology and geology behind the revolution in the United States are the same for both fuels (see box).Â

The unconventional oil and gas revolution

Oil and gas have long been produced from what are now called “conventional sources”: wells are drilled into the earth’s surface, and pressure that is naturally present in the field—possibly with help from pumps—is used to bring the fuel to the surface.Â

Other geological structures in the United States—shale rock and tight sand formations—have long been known to contain oil and gas. But the fuels are trapped in these formations and cannot be extracted in the same way as from conventional sources. Instead, producers use a combination of horizontal drilling and hydraulic fracturing, or “fracking,” during which fluids are injected under high pressure to break up the formations and release trapped fossil fuels. Both technologies have been around for more than a half century, but until recently, using them cost more than the price of crude oil and natural gas.Â

This changed when prices began to rise sharply in recent years. Producers were able to profitably extract oil and gas from these formations. At the same time, improvements in horizontal drilling and fracking technologies reduced the cost of using them.Â

This shale revolution has been helped by factors specific to the United States. First, the rights to below-ground minerals are private and landowners can lease these rights, which made it easier for small, independent oil and gas companies willing to take the risk—and to push for improvements in the technologies. Second, a competitive natural gas market with access to distribution networks by all producers allowed shale gas producers to market their product. Larger oil and gas companies...