No Fracking Way: Hydraulic Fracturing is Here to Stay

Few groups have benefited more from the US shale oil and gas revolution than the master limited partnerships (MLP) that are building critical midstream infrastructure to process the nation’s surging hydrocarbon production and transport these commodities to end markets.

Frenzied drilling in major unconventional plays has enabled the US to grow oil production for the first time in decades and overtake Russia as the world’s leading producer of natural gas.

Even more impressive, the US has accomplished these feats despite declining offshore produce in the Gulf of Mexico in the wake of the Macondo oil spill and subsequent moratorium on deepwater drilling.

Although dry-gas plays such as the Barnett Shale near Dallas and Fort Worth, the Fayetteville Shale in Arkansas and the Haynesville Shale in Louisiana in 2011 accounted for the bulk of unconventional gas production, liquids-rich shale plays–which offer superior wellhead economics–posted the strongest output growth.

For example, output from Appalachia’s Marcellus Shale last year doubled to almost 6 billion cubic feet of natural gas per day, while production from the Eagle Ford Shale in southeast Texas jumped by 64 percent, to about 3 billion cubic feet per day.

With natural gas prices likely to remain depressed for some time, we expect producers to continue to shift capital expenditures and drilling activity to liquids-rich plays.

Many of these regions lack sufficient midstream capacity to handle surging volumes of natural gas liquids (NGL), a group of heavier hydrocarbons such as ethane, propane and butane that occur in some shale fields and fetch higher prices than natural gas.

Midstream operators are addressing these bottlenecks by building additional takeaway and processing capacity. The Federal Energy Regulatory Commission, the agency charged with overseeing the interstate transmission of oil, natural gas and electricity, estimates that the industry plans to add enough processing and fractionation capacity to handle 700,000 barrels of NGLs per day by 2014. This construction boom also includes 1.3 million barrels per day in pipeline capacity.

And in a comprehensive report on this subject, the Interstate Natural Gas Association of America estimates that the US and Canada will need to spend USD83.8 billion to build and expand enough midstream infrastructure to support the upsurge in onshore production. Demand for these midstream assets will be met by MLPs.

On Dec. 8, 2011, MLP investors received a scare when the Environmental Protection Agency (EPA) issued a draft of Investigation of Ground Water Contamination near Pavillion, Wyoming, an inquiry prompted by residents’ complaints of unpleasant odors in their drinking water supplies.

The report suggested that nearby wells may have contaminated the drinking water and, predictably, elicited a chorus of calls to ban hydraulic fracturing–a key drilling technique used to extract hydrocarbons locked in low-permeability shale fields. Hydraulic fracturing involves pumping large quantities of water and a small percentage of chemicals into the rock formation at high pressure, which produces a network of cracks through which the oil and gas can flow.

The sensationalism and fearmongering that passes for analysis in all too many quarters suggested that the Obama administration would regulate hydraulic fracturing, throwing shortsighted MLP investors into a panic.

At the time, my colleague Elliott Gue pored over the EPA’s lengthy draft report and concluded that its findings were hardly a condemnation of hydraulic fracturing. Although the EPA’s report found that groundwater in the area contained elevated levels of natural gas and chemicals associated with drilling, the shallow nature of these wells and potential contamination from open pits and decades-old wells could also have been the culprits.

Elliott summed up his analysis of the provocative draft report in this excerpt from the Dec. 23, 2011, issue of MLP Profits, The Sound and the Fury:

The shoddy conclusions in the EPA’s draft report on groundwater contamination in, Wyo.–a unique situation, to say the least–shouldn’t prompt restrictive regulation of hydraulic fracturing in commercial-scale plays such as the Bakken Shale, the Eagle Ford Shale or the Marcellus Shale. Moreover, the current political and economic climate makes such a move untenable. You should regard investment opportunities pegged to this ‘eventuality’ with the utmost skepticism.

Subsequent developments suggest that the Obama administration will continue to support drilling in shale oil and gas fields and that the controversial practice of hydraulic fracturing likely won’t face excessive regulation.

For one, the EPA has softened its stance in a handful of high-profile cases in which the agency attributed water contamination to drilling in unconventional oil and gas fields.

In early March 2012, EPA Administrator Lisa Jackson agreed to Wyoming Gov. Matt Mead’s request that the agency cooperate with state officials in a joint review of the report linking water contamination in Pavillion to hydraulic fracturing. This process will include a more robust sampling process.

Meanwhile, at the end of March, the EPA withdrew an “imminent and substantial danger order” issued in 2010 which alleged that Range Resources Corp’s (NYSE: RRC) drilling operations in the Barnett Shale had contaminated at least two drinking-water wells with methane.

Throughout the dispute, the Railroad Commission of Texas, which regulates production and transportation of natural gas within the state, maintained that its own studies had determined that a gas-bearing formation other than the one targeted by Range Resources had contaminated the water wells.

More recently, the EPA delayed the release of a final rule establishing air pollution standards for hydraulic fracturing. Industry groups lobbied against the short time frame for compliance and argued that the agency’s emissions estimates for natural gas wells vastly overstated the problem.

Designed to limit the release of volatile organic compounds into the atmosphere, the rule requires producers to follow a two-stage process that includes flaring and the installation of equipment to capture natural gas lost leaked during the process. The EPA estimates that these processes are already in place at about half the fractured wells in the US.

The delayed rule, issued on April 17, 2012, extended the deadline for compliance to two-and-a-half years from two months and has received public support from a number of major industry groups, including the American Petroleum Institute, the American Chemistry Council and the Independent Petroleum Association of America.

EPA Administrator Lisa Jackson’s comments on the final rule were telling: “The president has been clear that he wants to continue to expand production of important domestic resources like natural gas, and today’s standard supports that goal while making sure these fuels are produced without threatening the health of the American people.”

Although President Barack Obama has come under fire in some quarters for his stance on deepwater drilling, he has embraced the role that growing domestic production and utilization of natural gas can play in reducing harmful emissions and securing energy.

During his 2012 State of the Union address, President Obama highlighted the nation’s rising output of natural gas and encouraged its widespread adoption for power generation and transportation. Such an endorsement effectively rules out overly restrictive regulations that would curtail hydraulic fracturing.  

The president also recently signed an executive order creating an Interagency Group to Support Safe and Responsible Development of Domestic Natural Gas Resources, a working group that will include a number of cabinet-level departments and regulatory agencies, including the EPA.

This order aims to improve coordination between the various federal agencies, and industry groups applauded the president’s move. The text of the executive order suggests that the task group will seek to balance the push for economic growth and energy security with environmental concerns:

[Natural gas] production creates jobs and provides economic benefits to the entire domestic production supply chain, as well as to chemical and other manufacturers, who benefit from lower feedstock and energy costs.  By helping to power our transportation system, greater use of natural gas can also reduce our dependence on oil.  And with appropriate safeguards, natural gas can provide a cleaner source of energy than other fossil fuels.

For these reasons, it is vital that we take full advantage of our natural gas resources, while giving American families and communities confidence that natural and cultural resources, air and water quality, and public health and safety will not be compromised.

Investors shouldn’t underestimate the economic benefits of the shale oil and gas revolution, particularly within the context of the subpar post-recession recovery.

For one, depressed prices for natural gas add up to lower utility bills for many US consumers at a time when households are focused on making every penny count. My colleague Elliott Gue wrote about this trend at length in America’s Overlooked Energy Advantages.

Meanwhile, a newfound abundance of ethane has revivified the domestic petrochemical industry, giving chemical manufacturers a dramatic cost advantage over producers in Asia and the Middle East that rely on naphtha and other oil derivatives for feedstock.

Over the past decade, multinational chemical producers such as Dow Chemical (NYSE: DOW) have gradually shifted their production base from the US to Asia (to build a presence in growing demand centers) and the Middle East (to take advantage of lower feedstock costs).

But in 2011 a number of major petrochemical producers have announced plans to restart shuttered crackers or construct world-class plants to take advantage of favorable pricing on ethane and propane, NGLs that tend to trade at a discount to crude oil but still exhibit similar price trends.

For example, Dow Chemical–the world’s second-largest chemical outfit–announced plans to restart its ethane cracker at its St. Charles complex, upgrade one plant in Louisiana and another in Texas to enable them to accept ethane feedstock and build a new ethylene production plant on the Gulf Coast in 2017. The firm aims to expand its ethane cracking capabilities by 20 percent to 30 percent to take advantage of the superior economics offered by the NGL. 

Royal Dutch Shell (NYSE: RDS: A) in June 2011 announced that it would build a world-scale ethylene plant in Appalachia that would source its feedstock from the Marcellus Shale. Meanwhile, Chevron Phillips Chemical–a joint venture between Chevron Corp (NYSE: CVX) and ConocoPhillips (NYSE: COP)–plans to build a major ethane cracker and ethylene derivatives facility in the Texas Gulf Coast region.

Local economies also continue to benefit from the feverish activity in emerging shale oil and gas plays. For example, North Dakota’s economy has boomed in recent years thanks to the Bakken Shale, while labor shortages in the Permian Basin, Eagle Ford Shale and Marcellus Shale should provide plenty of employment opportunities in these regions. In fact, the Pennsylvania Center for Workforce Information and Analysis estimated that the number of people employed by the mining and timber industries increased 17.4 percent from year-ago levels in November 2011, largely because of the Marcellus Shale.

Rather than focusing on the potential for restrictive regulations on hydraulic fracturing, MLP investors should consider a real threat that will affect certain energy-related publicly traded partnerships: The likelihood that domestic natural gas supplies to max out available storage capacity.

In the next issue of MLP Profits, Elliott Gue and Roger Conrad will share their near-term outlook for North American natural gas prices and the implications for owners of storage facilities and gathering, processing and long-haul pipelines.