Shale Gas Producers Could Face Financial Pressure (XOM, CHK, HK, RRC, XCO, SM, HAL, SLB)

The land rush to acquire and develop shale gas deposits remains as competitive as ever. But the way that the gas is extracted threatens to put a crimp in development of shale gas resources, as well as hit the bottom lines of producers and service companies that drill for shale gas.

Hydraulic fracturing, or ‘fracking’, is a technique that drillers use to fracture the tightly structured rock surrounding natural gas deposits. To accomplish this, drillers force a proprietary soup composed of water, sand, and chemicals into the surrounding rock causing it to crack and allowing the gas to flow out. But the composition of the fracking fluids is now under scrutiny, following charges that gas drillers are fouling local drinking water supplies.

This could turn into very bad news for producers like Exxon Mobil Corp. (NYSE: XOM), Chesapeake Energy Corp. (NYSE: CHK), Petrohawk Energy Corp. (NYSE: HK), Range Resources Corp. (NYSE: RRC), EXCO Resources, Inc. (NYSE: XCO), and SM Energy Corp. (NYSE: SM; formerly St. Mary Land and Exploration Co.). Oil field services firms could also feel the pinch. Two of the largest fracking fluid providers are Halliburton Co. (NYSE: HAL) and Schlumberger Ltd. (NYSE: SLB).

A committee of the US House of Representatives has notified the US EPA that “tens of millions of gallons of diesel fuel” has been injected into onshore gas wells, according to The New York Times. Diesel fuel has been commonly used as part of a driller’s fracking fluid, though both Halliburton and Schlumberger signed an agreement with the EPA in 2003 to “curtail” using diesel fuel in certain situations. When the Energy Policy Act of 2005 was passed, it included specific language exempting regulation of any sort on the fracking fluid, including the use of diesel fuel in the mixture.

The $64 question is whether or not the EPA will attempt to prosecute drillers under the Safe Drinking Water Act of 1974. The industry will fight any attempt by the agency to fine drillers for using diesel fuel in fracking in the past.

If the EPA chooses to levy fines against drillers, the industry will certainly take the matter to court, and may ultimately win. However, in the meantime, does drilling for shale gas slow down, or stop altogether?

Here’s where it gets tricky for producers. If they don’t continue to develop their leases, those leases could be lost. That, in turn, diminishes a company’s prospects, and could lead to a fall in share prices. If they try to continue drilling, they could face even larger penalties.

A more severe hit could come from the way production companies calculate their proved reserves, which is the measure that most investors use to determine the value of a company. If the EPA bans some chemicals, including diesel fuel, from being used in fracking fluids, drillers will have to get reformulated fluids tested and mixed before using them. And they might not work as well, which would force companies to re-calculate their proved reserves. That could really hurt.

Liability for past diesel fuel use, possible loss of leases if EPA intervenes, and possible lowering of proved reserves combine to make shale gas drilling a riskier business today than it was yesterday. It could take years to resolve all the issues, but one of these ought to be at the forefront: does the US continue to extract shale gas even if doing so means the country is poisoning its own people?

Paul Ausick