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Public scrutiny of the energy industry is increasing as a result of a series of well-documented environmental and public safety disasters for fossil fuel companies in recent months, such as Massey Energy’s (MEE) Upper Big Branch mine collapse, BP PLC’s (BP) massive Gulf of Mexico oil spill, and Pacific Gas and Electric Company’s (PCG) gas pipeline explosion in San Bruno, California. The BP Spill has already led to a six-month moratorium on deepwater (1,000 feet +) drilling in the Gulf of Mexico, with increased regulations almost certain to follow the resumption of drilling. But more regulation is very likely coming to all areas of the energy industry, including the rapidly growing shale gas sector. And these regulations are going to cut into already weak profits. Knowing which companies’ stocks are more vulnerable to these costs, and even which companies may benefit from the regulations, will help investors not only avoid losing money, but perhaps even profit from increasing regulation in the energy industry.

Shale drilling, for gas especially, but recently for oil as well, has increased dramatically in the last five years. As the leasing rush and drilling boom have grown, so have drilling accidents and anecdotes of the unadvertised environmental dangers of shale drilling.

One danger in shale drilling is the same in any type of drilling: blowouts. A blowout, speaking broadly, occurs when the upward force of the pressurized hydrocarbon deposit is greater than the downward pressure exerted by the drilling apparatus. A shale blowout occurred in the Marcellus basin of rural Pennsylvania this June 3rd, at a well operated by EOG Resources, Inc. (EOG). The state Department of Environmental Protection temporarily halted all drilling by EOG after the incident and is reviewing its oversight and rules in response to the incident.

Another, potentially more serious, problem related to shale drilling is groundwater contamination. Shale gas (and oil) has grown so rapidly because of a drilling technique known as high-volume, slick water hydraulic fracturing, or “fracking”. “Fracking” works by injecting water, mixed with chemicals and sand or ceramic proppant, at very high pressures, into the well, allowing hydrocarbons to flow to the wellbore. About half the very contaminated water comes back up with the hydrocarbons and is stored in pools by the drill site, but about half stays underground.

This water is the problem. Residents living around shale wells in Pennsylvania, Texas and Wyoming have reported that their drinking water has been contaminated by methane, heavy metals and other toxic chemicals and they blame the fracking fluids of shale drillers. Environments point to the town of Dimock, PA, where wells run by Cabot Oil & Gas Corp. (COG) are thought to have seriously polluted the town’s aquifer.

One result of the death of cap and trade legislation in Congress, which would have benefitted the relatively low carbon intensive natural gas industry, is that the federal government is pursuing its environmental goals through regulatory agencies, chiefly the EPA. Onshore shale drilling is currently not regulated at the federal level, except in the minority of cases when it is done on public lands, in which case it is overseen by the Bureau of Land Management. Indeed, the Energy Policy Act of 2005 gave the hydraulic fracturing process explicit exemption from the strictures of the Safe Drinking Water, Clean Air and Clean Water Acts. One possibility is that the EPA may move to end this exemption. It is currently conducting a scientific review of the dangers of hydro-fracking. State agencies, such as New York’s and Pennsylvania’s Departments of Environmental Protection, are conducting public hearings on shale drilling (the large Marcellus Shale, the target of a big leasing rush, sprawls across both states) and are likely to increase the regulatory burden on companies operating in that area.

We envision three possible scenarios for the regulation of the shale sector, each of which dictates slightly different strategies for the energy investor:
• Action on the state level
• Action by federal regulatory authorities, such as the EPA
• Federal legislation imposing rules on the shale industry

Action on the state level is already happening, as the environmental protection departments of various shale states conduct reviews of hydro-fracking. We expect state regulation to be less burdensome in areas traditionally sympathetic to the energy industry, such as Texas, Louisiana, Arkansas, Oklahoma, and Wyoming. In the Northeast, however, in Pennsylvania and especially in New York, we expect the state agencies to be more aggressive, especially as parts of the Marcellus shale in New York lie under New York City’s famously clean source of drinking water. In this scenario, therefore, we would recommend investors avoid stocks of companies whose growth plans rely on increased production from the Marcellus. These include Chesapeake Energy (CHK), Anadarko Petroleum (APC), XTO Energy, now a part of Exxon Mobil (XOM), Exco Resources (XCO), EOG Resources, Range Resources (RRC), Equitable Resources (EQT), Cabot Oil & Gas, and East Resources, now a part of Royal Dutch Shell PLC (RDS).

Action by the EPA is also possible. The agency is due to release a new study of the effects of hydraulic fracturing in 2012. A possible outcome of this study would be to remove the shale industry exemption from the terms of the Safe Drinking Water Act. This would require companies to disclose the chemicals used in the fracking fluid pumped into shale wells, putting pressure on them to stop using toxic ingredients.

EPA or Congressional action may well require shale drillers to take further, perhaps costly, steps to safeguard drinking water supplies from contamination during the fracking process. This could range from requirements that fracked wells be a certain distance from drinking water reservoirs, to mandates that wellbore casings be thicker to withstand cracking from the high pressures that occur during the pumping of frack fluid. In this case, investors may want to shift funds away from shale drillers, who would have to bear these costs, toward the service providers. These include divisions of Schlumberger (SLB) and Halliburton (HAL), and shale basin specialists Complete Production Services (CPX).

Whatever form it takes, regulation of the shale industry is likely on the rise. Profit margins and the rate of production growth for exploration and production companies are thus likely to be hurt. But investors may be able to find an upside by investing in companies that will provide the services necessary for compliance with the new regulations.

 

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.