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Controversial "Fracking" Drills Down on Energy Question

Hydraulic fracturing, or fracking, is releasing huge new supplies of natural gas and promising to revive the American economy with cheap energy.

IN THE RECENTLY RELEASED FILM PROMISED LAND, MATT DAMON plays a smooth-talking salesman for a natural-gas company who plays down concerns about the environmental impact of hydraulic fracturing, or fracking, to buy cheap drilling rights from farmers in a depressed area of Pennsylvania. Damon’s character sours on his job when he discovers the actions the company is willing to take to win, but he never really turns against fracking, as the potential bonanza of natural gas may offer the last chance of economic revival for this rural area.

Off the silver screen that message is resounding more than ever. Fracking has reinvigorated the U.S. oil and gas industry and brought the nation’s economy to the cusp of a historic transformation. The drilling technique is extracting massive new supplies of natural gas and sizable amounts of oil from shale rock formations, also known as plays, from Pennsylvania to North Dakota. Energy imports have declined so much over the past six years that the idea of U.S. energy independence — a pipe dream of presidents since the days of Richard Nixon — is suddenly a distinct possibility. The gas revolution also has the potential to spark a broader economic surge, creating millions of jobs and lighting a fuse under U.S. manufacturing.

Cheap, abundant energy generated by fracking will bring a “new American century,” contends Philip Verleger, an economist and former director of the U.S. Treasury’s Office of Energy Policy who runs his own energy and commodity consulting firm. He predicts that the U.S. energy boom will create 3 million jobs and boost economic growth by 1 to 1.5 percentage points a year between now and 2020.

“We can clean the clock of competitors who don’t have access to natural gas, and that overrides cheap labor abroad,” says Verleger, who served in the Carter administration. “Our trade deficit may go way down; we’ll have lower-cost energy; the Fed won’t have to tighten monetary policy; the dollar will be more competitive. And it’ll work no matter who is president. We will be energy independent in ten years.”

Verleger’s prediction is certainly ambitious, but there are several obstacles on the path to potential independence. First, the fracking industry must overcome its critics and demonstrate that it can continue to ramp up production without causing serious environmental damage. New York State, home to a potent antifracking movement, has imposed a moratorium on the practice pending review of an environmental study; Governor Andrew Cuomo is expected to decide by late this month whether to allow drilling to proceed. Scores of local governments across the country have banned it. Environmental concerns “can influence policymakers and can lead to lower investments and slow things down when we’re trying to generate energy and create jobs,” says John Felmy, chief economist at the American Petroleum Institute, a Washington-based trade organization. “There are legitimate issues that have to be properly addressed, especially when fracking is often misrepresented.”

The industry must also grapple with a spirited political debate about whether growing supplies of natural gas and oil should be kept at home or exported to world markets, helping to narrow the U.S. trade deficit. Manufacturers are eager to see new gas supplies directed at the domestic market to keep their energy costs down. Export advocates, however, are brandishing support from a long-awaited U.S. government study, released in December, that concluded that shipping natural gas abroad would provide a “net economic benefit.”

Notwithstanding these issues, however, the broader trend of cheaper, more abundant U.S. energy appears undeniable. Total dry production of natural gas increased by 18.9 percent between 2007 and 2011, to 22.9 trillion cubic feet, according to the U.S. Energy Information Administration. The agency projects that output will grow by roughly 50 percent by 2040 and that the U.S., which now produces 95 percent of the gas it consumes, will become a net exporter by 2020.

Crude oil production has also risen strongly, reflecting both the impact of fracking and that of offshore oil drilling. In September, U.S. petroleum production hit 6.5 million barrels a day, the highest level in nearly 15 years. The EIA projects that output will increase from an average of 6.4 million barrels a day in 2012 to 7.3 million this year and 7.9 million in 2014. Although oil production is forecast to decline after 2019, the agency expects output to remain above 6 million barrels a day through 2040. Tight oil, which is mostly generated by fracking, will account for 51 percent of total onshore production in the lower 48 states in 2040, up from 33 percent in 2011.

While energy companies jockey to make money in the new energy era, investment bankers are enjoying an M&A boom as oil giants such as Exxon Mobil Corp. snap up smaller players with significant shale stakes. Pipeline operators have also been merging at a rapid clip, with Kinder Morgan last year buying El Paso Corp. for $21.1 billion in one of the biggest-ever energy deals. Energy was the hottest M&A sector last year, with 588 deals worth a total of $151 billion, compared with 612 deals valued at $136 billion in 2011, according to data provider Dealogic.

Investors are scrambling to identify the winners and losers in this emerging new economy, betting on the stocks of oil producers, suppliers and infrastructure firms, and pouring money into partnership investments and energy sector funds.

“Fracking is a game changer,” says Mark Kiesel, a senior member of the investment strategy and portfolio management group at Pacific Investment Management Co. The onshore natural-gas and oil industry is growing three times as fast as the U.S. economy, he points out: about 6 percent a year versus 2 percent. “It’s thriving and one of the true bright spots for America,” he adds.

“The revolutionary implications of shale development in the U.S. are dramatic,” says Marc Lipschultz, global head of energy and infrastructure at New York–based investment firm KKR & Co. “Onshore in North America this development ranks second only to the beginning of the oil and gas industry in the U.S.”

The numbers tell the story. In the past decade shale gas rose from 2 percent of U.S. natural-­gas production to 40 percent. The nation has proven and potential natural-gas reserves of about 2,100 trillion cubic feet, according to the Potential Gas Agency, an industry body. Some estimate that is equal to about a 100-year supply. Developing this bonanza will be a major undertaking. Experts predict that unconventional gas production will attract a staggering $2 trillion in investment capital between 2010 and 2035.

“Fracking is a macroeconomic positive,” says Barry Bannister, equity investment strategist at St. Louis brokerage Stifel, Nicolaus & Co. But making microeconomic investments — and not just piling into the obvious names — will require careful analysis. “It will take a keen focus for investors to pick the winners,” says KKR’s Lipschultz. Oil and gas producers and refiners who either own shale assets or participate in their development will be among the biggest beneficiaries of the fracking boom. No wonder investors have bid up stocks like Houston-based Cabot Oil & Gas Corp., a natural-gas producer active in the Marcellus Formation in Pennsylvania. Its stock rose 29 percent last year after doubling in 2011. Though many of the smaller, more nimble independents arrived early in the shale-rich regions, some big energy companies have been slow to start drilling. Among them: Apache Corp., BP, ConocoPhillips Co. and Hess Corp.

Businesses that use natural gas as a raw material — chemicals and agricultural companies, along with a wide range of manufacturers — will continue to benefit from lower-cost energy. Dow Chemical Co., one of the country’s biggest consumers of natural gas, plans to invest $4 billion in new U.S. production facilities between 2012 and 2017 based on the promise of cheap energy. Dow projects that the facilities will create thousands of new U.S. manufacturing jobs.

Companies that supply products and services to drillers like Halliburton Co., Schlumberger and Baker Hughes — everything from trucking to construction and steelmaking — also stand to benefit. “We think fracking will bring a manufacturing renaissance,” says Donald Lindsey, chief investment officer of George Washington University’s $1.33 billion endowment. “The investment opportunities are vast and across many industries. It rivals the tech boom of the 1990s.”

Coal producers like Peabody Energy Corp. and Arch Coal are likely to be big losers as electric utilities and other energy users burn less coal and more gas, an outcome cheered by environmentalists.

Private equity titans Blackstone Group and KKR are raising multibillion-dollar energy funds to play the fracking game. Of the $5 billion that Blackstone has committed to energy investments, it is targeting more than $1 billion for early-stage oil and gas projects, many of them fracking plays. “The entire North American economy will benefit from fracking, especially manufacturing, with plastic and petrochemicals refining making significant gains,” says David Foley, CEO of Blackstone Energy Partners.

Since 2009, KKR has invested more than $2.5 billion in shale or shale-related businesses and put a further $4 billion into other energy-related investments, including energy infrastructure, housing for workers in the Bakken Formation and conventional oil and gas assets. In 2011, KKR and portfolio company Hilcorp Energy Co. sold properties in the Eagle Ford shale play in south Texas to Marathon Oil Corp. for $3.5 billion, three times what they paid only a year earlier. Last July, KKR agreed to pay up to about $200 million to take a one-third stake in Comstock Resources’ holding in the Eagle Ford.

Even as investors fund new fracking projects, they are keeping a close eye on the regulatory front. State and local authorities oversee most oil and gas production, but that could change. The U.S. Environmental Protection Agency is conducting a congressionally mandated study of fracking that is scheduled to be released in 2014; depending on the findings, the EPA may decide to issue new federal regulations.

Some states and towns have already set up roadblocks to new drilling. In addition to New York State, which has had its moratorium in place for four years, nearly 300 communities in at least 15 states have passed measures against fracking, and more restrictions are under discussion.

Environmental groups contend that fracking can contaminate drinking-water sources with underground methane and toxic chemicals used to fracture shale rock, such as lead, naphthalene, sulfuric acid and formaldehyde. Drillers use different cocktails of chemicals at each well, but a 2005 energy bill exempted the industry from the Safe Drinking Water Act’s rules for disclosing harmful substances, making it difficult to determine what has been used where.

“We don’t think it’s a long-term strategy,” says Wenonah Hauter, executive director of Food & Water Watch, a Washington-based nonprofit organization that’s campaigning to ban fracking on environmental grounds. “It’s irresponsible.”

Oil and gas executives insist that their unconventional drilling techniques are safe. “The industry has had a stellar record of safety compliance for fracking stimulation for over 60 years,” says Vincent White, spokesman for Devon Energy Corp. “The success rate is high, and while you never say never, if there are problems, they are rare.”

The Obama administration has mostly kept its distance from the debate. Secretary of Energy Steven Chu has said that he supports fracking but that we “need to develop it in an environmentally responsible way.”

Last year legislators introduced bills in both the House and the Senate that would have repealed the 2005 exemption from disclosure, but lawmakers didn’t vote on the measures.

THE HISTORY OF FRACKING DATES BACK TO 1866, when a Civil War veteran, Colonel Edward Roberts, received a U.S. patent for what became known as the Roberts torpedo. In a precursor of today’s technology, Roberts used nitroglycerin to break open shale rock. In 1949, Erle Halliburton, eponymous founder of the oil-field services company, led the first commercial application of hydraulic fracturing, in Duncan, Oklahoma.

In the fracking process companies drill vertically and then horizontally into the ground to reach shale rock formations one to two miles below the surface. They inject a high-pressure water-based mixture combined with sand and chemicals to crack the shale and release the embedded natural gas or oil.

In the U.S. the largest and best-known shale-gas basin is the Marcellus, located in the Appalachian region covering New York, Pennsylvania, Ohio, West Virginia and Kentucky. Among the 20-odd other U.S. shale plays are the Bakken in North Dakota and Wyoming; the Haynesville in Texas and Louisiana; the Barnett and Eagle Ford in Texas; the Fayetteville in Arkansas; the Antrim in Illinois, Michigan and Ohio; and the Woodford in Oklahoma.

In Canada the main shale-gas plays include the Horn River Basin and Montney in northeast British Columbia, the Utica in Quebec and the Horton Bluff in New Brunswick and Nova Scotia. Fracking has “revolutionized the oil and gas industry,” says Travis Davies, a spokesman for the Canadian Association of Petroleum Producers. “It has offset the natural production decline and sets us up for growth.” Even so, Canada has its opponents too: Nova Scotia has imposed a moratorium on fracking until mid-2014, and Quebec has suspended the practice indefinitely.

Beyond North America significant shale deposits can be found in Argentina, Australia, China, France, Mexico, Poland, South Africa and the U.K., but most of those countries are years behind the U.S. and Canada in their efforts to exploit their resources. Geologists know less about most shale deposits outside North America, such as whether they are as conducive to fracking as the big U.S. plays. And in some areas, notably Western Europe, environmental opposition is well entrenched. France is estimated to have as much as a 50-year supply of technically recoverable shale gas, based on current consumption rates, but President François Hollande has said he won’t allow fracking for environmental reasons.

U.K. shale has been found in Cheshire and Lancashire, where Cuadrilla Resources is exploring the Bowland play, the country’s most promising shale region. In December an assessment by the Department of Energy and Climate Change recommended development of shale plays, and the government of Prime Minister David Cameron lifted a suspension on shale-gas exploration. Later this year the British Geological Survey will release an estimate of onshore shale-gas reserves.

For decades fracking’s promise was untapped because of the cheap energy that prevailed after World War II. Conventional U.S. oil and gas production was in its heyday, and Gulf countries, led by Saudi Arabia, ramped up output in exchange for U.S. security guarantees.

Then came the first oil shock. In October 1973, Arab members of the Organization of Petroleum Exporting Countries imposed an embargo on oil exports to the U.S., much of Europe and Japan in retaliation for U.S. and Western support of Israel during the 1973 Yom Kippur War. Almost overnight gasoline prices skyrocketed across the West, governments imposed rationing measures, and economies fell into recession. Within a year global oil prices had quadrupled and “stagflation” had entered the lexicon. The era of cheap energy was over.

In a bid to counter the destabilizing impact of the embargo, President Nixon in November 1973 declared Project Independence, which aimed to make the U.S. self-sufficient in energy by 1980. Over the next several years, the government took tentative steps to reach that ambitious goal. In 1975, Congress passed the Energy Policy and Conservation Act, which created the Strategic Petroleum Reserve and established fuel-efficiency standards for vehicles. Two years later President Jimmy Carter elevated the Department of Energy to a cabinet-level agency. The government also invested billions in energy research and development. Those efforts paled in comparison with global events. When revolutionaries overthrew the U.S.-backed shah of Iran in 1979 and established an Islamic regime hostile to Washington and the West, the flow of Middle Eastern oil was again disrupted, resulting in a second oil shock.

Over the ensuing decades the American addiction to foreign oil worsened. By 1994, and for the first time since the 1950s, the U.S. was importing more oil than it produced. In the late 1990s, Mitchell Energy & Development Corp., a  Texas independent producer, applied hydraulic fracturing technology to shale formations in North Texas and launched the modern shale-gas revolution.

TODAY THE U.S. STANDS AT A POTENTIALLY dramatic turning point. After decades as the world’s largest energy importer, the country could soon begin to export significant quantities of gas. The old Nixonian ambition of full energy independence, long considered a fantasy, may now be within reach.

The prospect of gas exports is already stirring controversy, though. Some policymakers and politicians have joined with would-be exporters and their financial backers to make the case for exports, which they note would reduce the country’s trade deficit. Critics, including major energy consumers like Dow Chemical, argue that U.S. natural gas should be kept at home, at least for the foreseeable future, so that households and companies can continue to enjoy cheap energy and a nascent job-generating manufacturing renaissance can come of age.

Senator Ron Wyden, an Oregon Democrat and the incoming chairman of the Committee on Energy and Natural Resources, has repeatedly raised concerns about exporting oil and gas. But two other committee members, ranking Republican Lisa Murkowski of Alaska and Democrat Mary Landrieu from Louisiana, whose states are leading energy producers, have backed increased exports of natural gas.

To ship natural gas overseas, the commodity must be liquefied. It is currently permissible to import liquefied natural gas into the U.S., but companies cannot export it without the approval of the Department of Energy.

At the moment, U.S. gas prices are about a third of their European counterpart, making American LNG a prime candidate for profitable export. But domestic consumers, including manufacturers, fear that exports would reduce domestic supplies and drive up U.S. gas prices. The government study released in early December, conducted by NERA Economic Consulting, projected that exporting natural gas could raise the domestic price, then about $3.03 per 1,000 cubic feet, by 33 cents initially and $1.11 after five years.

From Massachusetts to Texas some 11 existing facilities are currently able to import LNG. These could be modified to export the commodity as well. As of late November, 20 companies had applied for government approval to export LNG from the lower 48 states. Pangea LNG, for example, filed a request to export up to 8 million metric tons per year of the product, worth about $1.3 billion at current prices, from its facility in Corpus Christi, Texas. Exxon Mobil and pipeline giant Kinder Morgan are attempting to get permits to build new LNG facilities.

“More exports and more tax revenue address the budget deficit, and with cheaper power due to lower gas prices, those are direct and indirect efforts to strengthen the U.S. economy and the dollar,” says Blackstone Energy Partners’ Foley.

Drilling down from the macro- to the microeconomic impact of fracking, pipeline companies and the makers of their supporting infrastructure can confidently expect increased demand for their products and services. In addition to Kinder Morgan, companies poised to benefit from the surge in infrastructure include Williams Cos., a Tulsa, Oklahoma–based pipeline operator; El Paso Pipeline Partners, a Houston-­based operator of gas transportation and terminal facilities; and Boardwalk Pipeline Partners, a Houston-based pipeline and storage company.

Assessing oil and gas producers with promising shale plays, Shawn Reynolds, a portfolio manager at Van Eck Global, a New York money manager, cites Irving, Texas–based Pioneer Natural Resources Co., an independent exploration company active in the Eagle Ford Shale and Permian Basin regions. He also likes Cimarex Energy Co., a Denver-based independent active in the Permian Basin in Texas and the western Oklahoma Cana-Woodford shale region. Among refiners, Reynolds recommends HollyFrontier Corp. and  Tesoro Corp.

In February 2012, Van Eck introduced a new fracking exchange-traded fund, dubbed Market Vectors Unconventional Oil & Gas, but so far it has pulled in only $18 million.

Even as investors work to identify profitable prospects, an increasingly vocal and growing citizen’s movement in the U.S. is focusing on fracking’s potential impact on the environment, from contamination of groundwater and surface water to air pollution and earthquakes.

Unlike some environmental nonprofits, Washington-based Earthworks does not take a ban-no-matter-what stance. Still, it asserts that the question of whether fracking can be done safely has not been adequately answered. It also contends that states are not enforcing existing regulations on drilling practices. “What’s at stake here,” says Alan Septoff, the group’s spokesman, “is protecting communities first.”

In October 2012, Earthworks published a report contending that contaminants associated with unconventional oil and gas production had been found in the air and water of many Pennsylvania communities.

Until the EPA releases its study on fracking in 2014, battles over the drilling practice will be fought at the state and municipal levels, with more local communities and governments taking independent action. In November, for example, Longmont, Colorado, some 30 miles northwest of Denver, voted to pass a measure to ban fracking, though the state has a pro-fracking governor and a long history of active drilling.

“It’s appropriate that states lead in regulating drilling activities,” says George Mitchell, the 93-year-old fracking pioneer and founder of Mitchell Energy (which he sold in 2002 to Devon Energy). “Each state and each shale formation has unique challenges related to issues such as water supplies and water treatment and disposal, community impacts and infrastructure needs.”

The courts will play a role, as well. The New  York State Department of  Environmental Conservation in late November faced its first fracking-related lawsuit when Lenape Resources, an Alexander, New York–based exploration company, sued the department and the western New York town of Avon, which had imposed a one-year moratorium on fracking. Lenape is seeking $50 million in damages. Two earlier court decisions in New York upheld bans on fracking in the towns of Middlefield and Dryden.

Barring new evidence or a drilling incident, however, environmental groups appear to be outmatched by the muscle of the oil and gas industry and the enormous economic potential that fracking seems to offer.

“Look, we import 10 million barrels of oil a day,” says Fadel Gheit, a senior analyst at Oppenheimer & Co. in New York. “If we produce gas instead, more people will be working, we’ll create millions of high-paying jobs, and the dollar will strengthen significantly.”

Christopher Li, president of Lockheed Martin Investment Management Co., which has more than $55 billion in assets, is similarly bullish about fracking’s impact. “Energy independence will lower the deficit,” he says. “It’s good for the earnings of U.S.-based manufacturing companies.”

Mitchell offers a different perspective. Energy independence is a myth, he says, because oil and gas are global markets. “That makes our economy interdependent with other nations’ energy markets,” he says. “The notion of American energy sustainability is more meaningful. To be sustainable, we need to focus more on the use of the cleanest energy supplies domestically and export our clean-energy technologies abroad.”

Sitting atop Marcellus shale rocks in State College, Pennsylvania, Seth Blumsack, co-director of the Energy and Environmental Economics and Policy Initiative at Pennsylvania State University, sees the fracking era lighting up one of several waves of economic change. “We have access to a lot more domestic energy than we thought,” he says.

And that’s not a bad thing. • •

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