A recent report from the US Energy Information Administration (EIA), US Crude Oil, Natural Gas, Natural Gas Liquids Proved Reserves, 2009, provides a reminder of how dramatically the shale gas revolution has changed the domestic market for natural gas.

EIA analysts estimate that in 2009 US proved reserves of “wet” natural gas–which includes coproduced natural gas liquids (NGL)–increased by 11.3 percent to 283 trillion cubic feet, the highest level since 1971. As you can see in the graph below, the country’s proved reserves of natural gas and NGLs have expanded every year since 1999.

Much of this recent growth stems from activity in leading shale gas plays. In 2009 discoveries in shale gas fields contributed 24.8 trillion cubic feet (tcf) of new proved reserves, more than half of 2008’s additions. This brought the total proved reserves in unconventional plays to 60.6 tcf, or 21 percent of total US natural gas and NGL reserves.

Although many producers plan to slow activity in dry-gas plays such as the Haynesville Shale, drilling in the Eagle Ford Shale and other liquids-rich areas should accelerate because of the superior economics.

Production from unconventional plays has also increased dramatically, more than doubling from 1.12 tcf in 2007 to 3.11 in 2009.

Source: Energy Information Administration

Based on the horizontal rig rate and reports within the industry, shale gas output likely grew at a rapid rate in 2010, despite depressed natural gas prices. As we explained in Pugh Clauses and Shale Gas Activity and Short-Term Outlook for Natural Gas, gas prices have decoupled from drilling activity because of high-value liquids in certain plays, efforts to hold leases by production and huge capital flows from JVs with major oil companies.

The shale gas revolution should continue well into the future, according to the early release of the EIA’s Annual Energy Outlook 2010. Check out the projected growth in shale gas output and its increasing contribution to overall production.

Source: Energy Information Administration

Although much of this growth will occur in shale gas plays located in traditional energy-producing regions, output from the northeast–historically, more of an energy-consuming area–is also expected to rise substantially.

Source: Energy Information Administration

Much of this production growth will come from the Marcellus Shale, a sedimentary formation that runs beneath Pennsylvania, New York and West Virginia. Development in the Pennsylvania portion of the play has progressed at a rapid pace. In 2007 the commonwealth received about 100 requests for vertical wells, and permitting requests in 2008 increased to about 500 vertical and horizontal wells. Thus far in 2010 regulators have granted more than 2,700 well permits, primarily for horizontal wells.

Along with hydraulic fracturing, horizontal drilling is one of two key advances that have enabled producer to tap the massive reserves formerly locked in the Marcellus and other low-permeability formations.

A horizontal well branches off laterally from an initial vertical drill hole, exposing more of the productive layer to the well. Fracturing, or stimulation, increases the permeability of the reservoir rock, allowing natural gas to flow from the reserve rock into the well. This process involves pumping large quantities of water and a small percentage of chemicals into the rock formation at high pressure, producing a network of cracks. The inclusion of a proppant–typically sand, sand coated with ceramic material or ceramic material–ensures that these passages remain open.

Drilling at this fevered pace has rapidly increased the state’s natural gas output. According to the Pennsylvania Dept of Environmental Protection, the state’s 632 reported well s in the Marcellus Shale yielded 180 billion cubic feet of natural gas between July 1, 2009 and June 30, 2010. As a point of reference, the latest data from the EIA indicates that the commonwealth’s shale gas play yielded 65 billion cubic feet of gas in 2009.

Production growth should remain robust in 2011 as operators rush to secure leaseholds. Activity in the play’s NGL-rich window should hold up, regardless of whether natural gas prices remain depressed.

Nevertheless, political and regulatory risks have put some investors on edge. Some of this comes with the territory: Pennsylvania and New York are hardly hot spots of energy production, especially compared to Texas or Louisiana. Here’s a quick rundown of the regulatory challenges in Pennsylvania and New York and their implications for gas producers.

Pennsylvania

Pennsylvania has a long history of producing natural gas from a large number of conventional wells, but the level of development and drilling in the Marcellus Shale is an entirely different beast.

Although Pittsburgh’s city council and commissioners in nearby South Fayette Township made headlines when they banned drilling within their bounds, neither area is a major focus for producers–these bans are somewhat empty gestures.

Of late, much of the regulatory uncertainty has stemmed from questions about the extent to which production from the Marcellus would be taxed at the state level. For most of 2010 Pennsylvania’s General Assembly was locked in a fierce partisan debate over whether the commonwealth should institute an extraction, or severance, tax on natural gas produced from the Marcellus. These levies are common in energy-producing states; 39 states, including Texas, Arkansas and West Virginia currently have such a policy on the books.

Although such a measure would seem like a slam dunk in a state facing a substantial budget deficit–it’s one of the few revenue-generating options available that wouldn’t involve raising Pennsylvanians’ taxes–incumbent Democratic Gov. Ed Rendell ultimately failed implement an extraction tax during his last year in office. This failure wasn’t for lack of trying.

In early July Rendell signed Act 64 into law, committing to passing an extraction tax by Oct. 1, 2010, that would be effective by Jan. 1, 2011.

To break a deadlock in the General Assembly, Rendell proposed a compromise measure that called for a 3 percent severance tax in fiscal year 2010-11, a 4 percent tax in 2012 and a 5 percent tax thereafter. Sixty percent of this revenue would have flowed to environmental projects and to municipal governments to mitigate the impact of drilling–the heavy equipment, for example, takes its toll on roadways–while the remaining 40 percent would have gone to the commonwealth’s general account.

The proposal fell upon deaf ears. Republicans countered with a plan that would have imposed a 1.5 percent tax in a well’s first two productive years, before increasing to 5 percent for the remainder of its life. Such a scheme would have enabled producers to recoup early costs.

The failure to reach a tax compromise, coupled with Republican Tom Corbett’s victory in the gubernatorial election, suggests that producers will be free of an extraction tax for the time being.

The governor-elect has emphasized that he won’t impose a severance tax on natural gas drilling. Of course, given the commonwealth’s weak fiscal state, it’s likely that Corbett will cook up some sort of revenue-generating scheme that taps the burgeoning activity in the Marcellus Shale. However, one can rest assured that whatever plan Corbett puts in place will involve a great deal of consultation with the Marcellus Gas Coalition, an industry trade group headed by former Pennsylvania Gov. Tom Ridge.

Meanwhile, incumbent Gov. Rendell’s executive order that banned the lease of state forest land for natural gas drilling is hardly a blow to an industry that has plenty of acreage left to develop.

The bottom line: The Marcellus Shale should remain a hotbed of drilling activity, a point underscored by Chevron’s (NYSE: CVX) recent acquisition of Atlas Energy (NasdaqGS: ATLS).

New York

Whereas natural gas production has boomed in Pennsylvania, horizontal drilling and hydraulic fracturing have been a harder sell in New York, where concerns about the environmental impact of these production techniques remain a serious hurdle. In fact, shale gas production in New York has remained virtually nonexistent over the past three years.

Few of the major Marcellus operators have exposure to the New York portion of the play, in part because of regulatory uncertainty within the state. Incumbent Gov. David Paterson raised eyebrows ealier this month when he issued an executive order stating that no drilling permits will be issued until the state’s Dept of Environmental Conservation (DEC) completes a comprehensive review of the environmental impact of horizontal drilling and hydraulic fracturing.

This announcement was hardly news. New permits have been on hold since 2008, when the DEC began working on the Supplemental Generic Environmental Impact Statement (SGEIS). However, the executive order also gave officials until June 1 to publish a revised draft of proposed environmental standards. This new draft would have to be made available for public comment for at least 30 days.

Perhaps more distressing for would-be drillers, Gov.-Elect Andrew Cuomo appears unlikely to kowtow to the industry’s demands. A hostile regulatory situation in New York won’t impact our favorite players in Pennsylvania’s Marcellus Shale, nor should the latest news from the state affect drilling in other US shale plays.

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