The Fracking Controversy

Dear Reader,

Last night, I was reading through the annual report for Tesla Motors. The company is constantly in the financial news; hence it made sense to take a closer look. At its IPO, I simply dismissed it as another green-energy pipe dream. But after a closer look, the company appears to have a product that can serve a niche market regardless whether the electric car revolution takes off.

I haven’t crunched the numbers yet; so I can’t make a recommendation on the stock. Also, I’ll definitely want to get the Casey Research tech team’s opinion before making a strong judgment. But aside from the core business, there’s something else to discuss here – regulation.

Tesla Motors is the business that almost everyone should love. They build electric cars that will reduce pollution and could decrease America’s dependence on foreign oil. Furthermore, Tesla manufactures in the United States, with the new model S factory opening in Fremont, CA. While many companies have cut back on workers, Tesla is adding more. During the height of the crisis, it only laid off 60 workers. Today, it has 900 employees, and its website shows 131 new job openings.

Tesla Motors has created both good manufacturing jobs as well as engineering and tech positions. Why doesn’t this sort of thing happen more often? Well, some of the obstacles in Tesla’s path may give us a clue. The company faces numerous regulatory impediments. I simply wanted to list four of the most absurd so that you can get the idea. 

1.  Tesla Motors was fined $275,000 for violating the Clean Air Act. Apparently, the company did not acquire the necessary certificates of conformity for emissions from the EPA. Let’s put this in very blunt and simple terms. When a zero-emissions electric car company is fined under the Clean Air Act, the stupids have won. 

2.  One of the coolest aspects of a Tesla car is its silence. That’s right. With no internal combustion engine, the Teslas are an amazingly quiet ride. In fact, the company widely advertises this feature. This will continue to be a competitive advantage of the electric car until perhaps 2013. Why 2013? Well, in January 2011, Congress passed and Obama signed the Pedestrian Safety Enhancement Act.

According to the law, the NHTSA (National Highway Traffic Safety Administration) will set minimum noise requirements for electric vehicles and hybrid electrics traveling at low speeds. The vehicles will be made louder in order to protect vision-impaired pedestrians from the extremely quiet electric cars.

3.  Since Tesla’s offering is very specialized, the company decided to create its own distribution chain rather than go through independent dealers. Since the cars are so unique, this does make sense. Currently, the company has opened 16 dealerships around the country. Plus, it sells many cars over the Internet. 

However, creating a company-owned sales network comes with additional regulatory challenges. For example, according to Kansas law, residents cannot purchase cars from companies without a licensed physical location within Kansas. If a Kansas resident orders a Tesla online, it is illegal for the company to deliver the car. It can only do so by opening a store in the state first. Considering that Tesla dealerships are only located in major metropolitan areas around the world, most Kansas residents can forget about owning a Tesla.

4.  The state of Texas has another peculiar distribution law. There, the vehicle manufacturer cannot be simultaneously licensed as an auto dealer. The law essentially legislates a middleman between the manufacturer and the customer. Sure, Tesla could do this, but their entire distribution model is based on the opposite. They simply want to sell their cars with their own sales team. Is that so much to ask?

These are just some minor regulations. The company has bigger fish to fry, such as car safety standards. However, these absurd examples give a hint of the challenges the company faces. With these sorts of obstacles and a tangle of regulation at every turn, is it so hard to conceive why jobs are going overseas? Modern entrepreneurs must have more than a good idea; they sadly need an in-depth knowledge of regulation as well.

And now on to the rest of the issue. First, the Casey Energy team will discuss the environmental impact of fracking and what this could mean for the natural gas industry. Then I’ll finish with a short comment on Bernanke’s upcoming press briefing.

The Fracking Controversy

By The Casey Research Energy Team

The news that Blackstone Group LP (BX), the world’s largest private equity firm, is set to invest $1 billion in unconventional oil and gas projects in North America through a joint venture with Alta Resources has cemented a spotlight on fracking.

A U.S. Senate committee is currently conducting a hearing on the safety of hydraulic fracturing, as it is formally known. The province of Quebec, the state of New York, and the entirety of France have recently banned the technique. And two new studies claim that fracking-derived shale gas is actually worse for the environment than mining and burning coal. With so many claims flying around about this unconventional practice, let’s get a closer look at the facts.

Fracking is a drilling technique that involves pumping large volumes of water, sand and chemicals into deep shale deposits to fracture the rock and free the oil or gas. Drillers seeking to pull more oil and gas from hard rock deposits have been fracking since the 1950s, but in the last decade advancements in horizontal drilling techniques have taken fracking to a new level.

Fracking has enabled us to extract gas from shale deposits, which are often more than a mile underground. The gas in these deposits used to be inaccessible, but now that it can be extracted, and as a result, shale gas has transformed the North American natural gas landscape. In the chart below, the increase in Lower 48 onshore production over the last 10 years stems primarily from shale gas discoveries.

Shale gas deposits now provide 25% of America’s natural gas and are expected to provide 45% by 2035. In 2010, the nation produced 4.87 trillion cubic feet of shale gas, a 57% increase from in 2009. Shale gas discoveries accounted for 90% of the increase in America’s domestic gas reserves in 2009 – a year when gas reserves grew by 11% even though prices fell by a third – and shale gas now represents 21% of the nation’s total gas reserves.

The dramatic shift to shale gas has three drivers. First, horizontal drilling advanced to a level where drillers became able to frack horizontally. Fracking has been used to extend the lives of vertical wells since 1949, but vertical fracturing cannot retrieve shale gas at economic levels. Horizontal fracking can.

Second, the world’s easy-to-reach, conventional gas fields are starting to run dry. That precipitated an increase in the price of natural gas. When a commodity is worth more, companies become willing to spend more finding it, and thus was born today’s frantic fracking campaign.

Third, the United States hates that it is reliant on OPEC oil. When fracking revealed a wealth of domestic natural gas, that natural gas quickly became the “bridge fuel” in the nation’s energy plan, a cleaner-burning fuel than oil or coal that the country can use to wean itself off foreign oil as it transitions to renewable energy sources. Natural gas exploration has almost been cast as an act of patriotism.

It has also found major support from the federal government. President Obama has promoted natural gas as part of America’s clean energy future, but the real support for fracking came from President Bush. In 2005, the Bush administration drafted and passed the Energy Policy Act, a wide-ranging energy bill crafted by Vice President Dick Cheney. (It is relevant to note that Dick Cheney ran Halliburton, the company that pioneered fracking and is highly active in U.S. natural gas exploration, before joining politics.)

The Energy Policy Act explicitly exempted fracking from the requirements of the Safe Drinking Water Act, the Clean Air Act, and the Clean Water Act. The Halliburton Loophole, as it has become known, enables gas companies to pump millions of gallons of fracking fluid into old wells or to leave the fluid evaporating in open pools, without having to identify the chemicals in the fluid. Those chemicals include benzene, toluene, boric acid, xylene, diesel-range organics, methanol, formaldehyde, and ammonium bisulfite.

It is this fracking fluid that causes the most concern. It takes up to 8 million gallons of water to frack a well, and a well may be fracked up to 18 times. With each round, about half of the fracking fluid returns to the surface along with the gas, via the collection pipes. The gas is piped to compressor stations, where it is purified and compressed for transport. The returned fracking fluid, now called wastewater, is either trucked to water treatment plants that may or may not be designed to handle fracking chemicals, reinjected into old wells, or stored in large, tarp-lined pits, where it is allowed to evaporate.

It is no great surprise that the rapid growth in fracking has been matched by an equally rapid growth in opposition. The wells themselves are eyesores for some; to build the roads and drill pads, hundreds of thousands of acres of land have been disrupted. However, the big issue is water contamination. As use of the technique has spread, it has been followed by thousands of incidents of water contaminated by metals and volatile organic compounds that have led to health problems for people, livestock and wildlife.

The natural gas industry claims that the one million currently producing, hydraulically fractured wells in the United States were drilled without causing a single confirmed case of groundwater contamination. That is not true. In Pennsylvania, the Department of Environmental Protection acknowledged a contamination of the aquifer that fills household wells in a rural area of Dimrock after more than 60 wells were drilled in a 9-square-mile area.

The fracking operations turned the water brown and imbued it with dangerously high levels of methane, iron and aluminum. Fracking fluids leaked into streams, turning them garish colors and killing fish. One woman’s water well blew up. A family was evacuated from their house because of dangerous methane levels.

Shale formations are typically 5,000 to 8,000 feet deep, way below groundwater aquifers that usually sit just 1,000 feet below surface. As such, it is not likely that the frac gas and fluids travel all the way up to the aquifers through fractures. Contamination more likely occurs through poor cement well casings that allow fracking fluids and methane to escape all the way up the pipe, including at groundwater levels.

In addition, since the Halliburton Loophole exempts fracking from abiding by most environmental regulations, the above-ground handling of return wastewater and the airborne pollution produced through processing add significant risks to the fracking process. For example, Fort Worth, Texas, sits atop a very productive shale formation. Chemical emissions from natural gas processing facilities in and around Forth Worth now match the city’s total emissions from cars and trucks.

Fracking still enjoys wide-ranging support, for good reasons. The lease fees that drilling companies pay to landowners are enough to turn many citizens into supporters. The price to lease an acre of Marcellus Shale, the huge shale play that stretches from West Virginia to New York, continues to climb. Twenty years ago, it was just $25; now it averages $5,000. The industry creates thousands of job and pumps lots of money into state coffers. And it provides natural gas, the clean energy of our near-term future. Right? Well, maybe.

The part that may not be right is the “cleanliness” of natural gas. Two new studies out of Cornell University are poking holes in natural gas’ clean-and-green reputation, suggesting that the rush to develop America’s unconventional gas resources will likely increase the nation’s carbon emissions rather than decrease them.

Natural gas is considered clean because, on combustion, it emits roughly half the carbon dioxide of coal and about 30% that of oil. The problem, according to lead author Robert Howarth, is that combustion is only one part of the natural gas life cycle; during other parts of the cycle, a lot of methane is lost.

The study suggests that  between 3.6% and 7.9% of the methane in natural gas is lost from the time a well is plumbed to when the gas is used. On top of that, a recent study from the Goddard Institute for Space Studies at NASA suggests an interaction between methane and certain aerosol particles significantly amplifies methane’s already potent greenhouse gas effects. In addition, thousands of trucks are driving every minute of every day to bring fracking fluid to drills and to remove wastewater. When all is factored in, Howarth and his colleagues conclude the greenhouse gas footprint of shale gas is likely 20% greater than coal per unit energy, and may be as much as twice as high.

There are many caveats in the study. The data Howarth used was thin, by his own admission, in large part because the industry discloses so little. And much of the methane now leaking out of shale gas operations should be relatively easy to seal in. But if nothing else, the study should give lawmakers reason to pause before continuing their wide embrace of all sources of natural gas.

Along those lines, many people oppose the overall concept of a bridge fuel. The question is: how long and wide should the bridge be? And if Howarth is right and shale-derived gas is worse for the environment than coal and oil, should shale gas be part of the bridge?

These are the questions that governments around the world are wrestling with. In the U.S., a Senate Environment and Public Works Committee is currently hearing testimony in an effort to assess the safety of hydraulic fracturing. The Environmental Protection Agency (EPA) is also studying fracking, under orders from Congress. The EPA study is a comprehensive look at whether fracking taints water supplies, and initial results are not expected until 2014.

Some jurisdictions are not waiting for official study results. New York City and Syracuse, New York, have banned fracking in their watersheds, citing a study that concluded fracking could pose “catastrophic” risks to the prized local water supply. New Jersey is considering a ban, and Pittsburgh has prohibited the practice within city limits. The Canadian province of Quebec recently banned fracking completely, even though the province hosts considerable shale gas potential. In Australia, fracking has been sweeping the Queensland countryside, and a furor is building among landowners. Shale exploration is similarly spreading quickly and causing strife across Europe.

Nevertheless, Blackstone’s $1 billion entry into the field suggests fracking is still a hot topic. Blackstone is not the only major making a major shale splash: a year ago, Indian materials and energy giant Reliance Industries struck a deal with Pennsylvania-based Atlas Energy to team up in developing Atlas’ more than 500,000 acres of Marcellus land. The deal is worth $1.7 billion over five years, or $3.5 billion over 10 years.

So what should the investor do? First, it is not important to decide whether or not fracking is damaging to people and the environment. The Senate committee and the EPA are working on that (albeit through numerous politicians and lobbyists – good luck to them). What the investor needs to do is the same as always: separate the wheat from the chaff.

In that analysis, remember these points.

  1. Unconventional exploration, including fracking, is a phenomenon that will forever change the face of hydrocarbon exploration. We applaud those trying to find new ways to tap into the earth’s resources.
  2. Natural gas prices are depressed because of oversupply in North America. Oil prices, on the other hand, are high. If you want exposure to unconventional exploration, choose a company that is working in both areas, or potentially just in unconventional oil. You rarely win when you’re fighting against a low commodity price.
  3. Every successful development in exploration attracts bandwagoners, companies that want to ride the wave even though they are not really involved in the action. Check maps to verify a company’s land position is actually within the basin in question; check cash balances to see if the company has enough money to drill. Do your due diligence.
  4. Where there are congressional committees and controversy, laws are apt to change. Fracking is coming under considerable scrutiny at the state and federal levels, so keep your eyes peeled for news about challenges or change to the regulations governing fracking.

While oil and gas companies can be terrific profit opportunities, rising prices also create opportunities in the renewable sectors, making them more economic. Learn which “green energy” is not only more viable and cheaper than solar and wind, but can also provide investors with stunning gains – it’s so great, even Warren Buffett has a stake in it. Get the details here.

Another Take on Bernanke’s Words

By Vedran Vuk

Bloomberg had an interesting take on the upcoming Fed press briefings. In the article, “Bernanke Briefings May Offset Fed Hawks With Words as New Tool,” the author takes the same angle as I did a few weeks ago. These press briefings will be no innocent chit-chat with the press. Instead, the briefings are an intentional policy tool.

But here’s the interesting part: this article takes the complete opposite side of what Bernanke will say. In my opinion, he will say something to alleviate inflation concerns. Furthermore, the dollar is getting too weak, and he should be tempted to strengthen it with his words. However, this article believes that Bernanke will reiterate the goal of low interest rates for an extended period of time. And he does make a good case.

However, if Bernanke does this, the result could be fatal for the U.S. dollar. With central banks around the world raising rates, a promise of extended low rates could absolutely crush the dollar. I agree that Bernanke is a fairly crazy guy and a weak dollar doesn’t scare him much. But does he really want the USD weakened to $1.50/€ or worse? I truly hope that’s not the case.

Additional Links and Reads

Standard & Poor’s Puts ‘Negative’ Outlook on U.S. AAA (Bloomberg)

Americans Still Split About Whether Their Taxes Are Too High (Gallup)

What the Top U.S. Companies Pay in Taxes (Forbes)

Well, that’s it for today. But I just want to make one more comment for the day after reflecting on my intro and the Energy team’s article. Natural gas fracking gets an exemption from the Clean Air Act, and Tesla’s electric cars get the fines. It’s a crazy world, folks.

Vedran Vuk
Casey's Daily Dispatch Editor

Apr 18, 2011