Last week, I discussed why investors shouldn't expect the EPA to finish off thermal coal, despite pending regulations and falling coal miner share values. While the stocks of companies with exposure to U.S. shale gas haven't fared quite as badly as coal mining companies in the week since President Obama's election victory, they have still underperformed the broader S&P 500 Index by a significant margin. The decline has been fairly uniform across different segments of the industry, including shale gas producers such as Chesapeake Energy (NYSE:CHK) and Devon Energy (NYSE:DVN); equipment suppliers such as Halliburton (NYSE:HAL); and pipeline operators such as Kinder Morgan Energy Partners (NYSE:KMP) and Buckeye Partners (NYSE:BPL). All are down 6-10% since November 7 at the time of writing amid headlines on a pending EPA study on hydraulic fracking and groundwater contamination, and possible regulation of the practice.
Interestingly, natural gas prices (as represented by the U.S. Natural Gas Fund ETF [UNG]) are up 4% over the same period (see chart), which is normally a boon for producers at the very least. The combination of falling share prices across the industry and rising natural gas prices is indicative of falling production expectations. Given the International Energy Agency's forecast of increasing U.S. natural gas production in the coming years (largely in the form of shale gas via fracking), the only reason for an actual fall in production would be the imposition of government restrictions on fracking.
Studies And Regulations
In December 2011, the EPA reported finding evidence of groundwater contamination from fracking at two wells in Wyoming. The study containing the findings did not undergo peer-review and came under attack for, among other things, being unable to show statistical significance. Nonetheless, it has served as the basis for fear-mongering statements from media sources on both sides of the political spectrum, ranging from "we run the risk...[of] exposing children and others to potentially dangerous chemicals" (Huffington Post) to "Obama EPA set to derail fracking, kill 1.7 million jobs" (The Washington Times). Meanwhile, the EPA is moving ahead with a national study on the effects of fracking on groundwater, a preliminary version of which will be released by the end of 2012 (the final version isn't expected until 2014).
Judging from the referenced media articles, the industry's big concern is that the EPA's report will generate results supporting the imposition of strict controls on fracking. This move would be consistent with the Obama administration's alleged goal of driving the fossil fuel industry out of business. According to this particular line of thought, fracking has greatly increased fossil fuel production in the U.S., and is thus Public Enemy #2 (coal mining, of course, being Public Enemy #1) as far as the Obama administration is concerned.
I won't attempt to refute allegations that the Obama administration is broadly opposed to the use of fossil fuels. While I don't give much credence to political campaign speeches, this is the same administration that would have implemented a national cap-and-trade program but for Martha Coakley's infamous lack of baseball knowledge. That said, the EPA doesn't have a record of finalizing major regulations on the basis of preliminary studies, particularly when those studies don't have the strong support of the peer-reviewed literature (and the existing literature on the subject of fracking and groundwater contamination has been anything but).
The most famous example of the current EPA walking back major regulations on the basis of new findings involved its implementation of the revised Renewable Fuels Standard (RFS2) under the Energy Independence and Security Act (EISA) of 2007. The EISA modified the original RFS (a biofuel mandate) to include greenhouse gas (GHG) reduction thresholds for biofuels included in the mandate. Shortly before the legislation was passed, a paper published in the journal Science (lead-authored by Tim Searchinger, a visiting professor at Princeton) purported to show that the production of U.S. corn ethanol caused widespread rainforest destruction in Brazil, an effect known as "Indirect Land-Use Change" (ILUC). Attributing the GHG emissions from this deforestation to corn ethanol caused it to fall short of the required GHG reduction threshold under the RFS2, and as a result, not qualify for the mandate under the EPA's preliminary rulemaking. This caused something of an uproar among corn ethanol producers, who considered the corn ethanol mandate to be important for the industry's continued domestic growth.
It should be noted that the EPA's preliminary rulemaking was published several months after President Obama's inauguration and Lisa Jackson's appointment as EPA director, a position that she still holds. Corn ethanol production had come under significant attack from environmental and other left-leaning groups that considered it to be extremely harmful to both the environment and developing countries. Any move to have corn ethanol removed from the RFS2 mandate would have been favorably received by many supporters of the Obama administration. In many ways, corn ethanol production was as controversial then as fracking is now.
It wasn't long until other researchers began to identify a number of flaws with Mr. Searchinger's study. It suffices to point out that a subsequent paper by most of Mr. Searchinger's co-authors found that the results of the original analysis were very sensitive to a number of questionable assumptions. Studies from other universities came to a similar conclusion. That's when the EPA did something interesting: it revised its preliminary rulemaking, which was based on a peer-reviewed study in one of the world's premier physical sciences journals, to reflect newer peer-reviewed studies published in much lower-impact journals. In the process, it recalculated the GHG reduction threshold for corn ethanol and determined that it was high enough to qualify for the RFS2 mandate. The result, which was quickly slammed by environmental groups, represented a complete shift in the EPA's stance on corn ethanol.
The EPA has also demonstrated a willingness to revise its own work on groundwater pollution via fracking. Its aforementioned tests showing contamination in Wyoming, for example, were ultimately redone in cooperation with the U.S. Geological Survey to correct for flaws in its methodology. The new findings ended up being very similar to the EPA's original findings. The EPA has pledged to submit the final Wyoming report to peer-review, and is likely to do the same with the final version of its national fracking study. While peer-review is no silver bullet and can be manipulated by unscrupulous researchers, it does provide an extra layer of confidence in the validity of the results.
The Long Road To Regulation
Let's assume for the sake of discussion that the EPA's national study on fracking finds, on the basis of shoddy methodology, a very strong causal link between fracking and drinking water contamination. Even under that scenario, it would take several years for restrictions on fracking to be developed, finalized, and fully implemented. First, the preliminary national fracking study will be subject to a lengthy public comment period prior to the publication of the final version in 2014. If the path taken by the Wyoming study is any guide, several weeks of a public comment period will also follow the release of the final version, with several weeks (and possibly months) of peer review coming on the heels of the public comments. Then, and only then, will the "final" version of the study truly be final.
A single study does not a regulation make, of course. Again, assuming that the EPA's national fracking study finds a strong enough causal link between fracking and drinking water contamination to merit a wide-reaching regulation, the preliminary regulation will take up to a year to draft. Several months of public comments will follow before a final regulation is released. Based on past EPA regulations on both coal and biofuels, the final regulation will either grandfather in existing wells or give producers a period of two to four years to bring their wells into compliance. The path from the release of the study's preliminary results to final implementation of a consequent regulation will take several years to complete, and its winding nature will give stakeholders multiple opportunities to ensure that only rigorous scientific results are used. I wouldn't be surprised under this scenario if the final regulation didn't appear until after President Obama's second term ends, in which case a potential GOP replacement could promptly scrap it.
Regulations As Bargaining Chips
Finally, it should be noted that the EPA is not an independent agency. Its regulations must ultimately receive the implicit authorization of the president before they are implemented. President Obama has at least two (and possibly four) years of governing with a divided Congress. Therefore, he'll need at least some Republican support if he is to pass any legislation during this time. If the price of those Republican votes is to scrap proposed EPA regulation of fracking, then expect to see some political horse-trading. While the Democratic majority in the Senate prevents the GOP from passing any legislation that explicitly bars EPA regulations, it still has the ability to require their use as bargaining chips in any legislative negotiations.
If recent market moves are any indication, investors in fossil fuel producers fear that President Obama's re-election signals an unleashing of the EPA. While the current EPA's attitude toward fossil fuels is certainly less friendly than that of the agency under the Bush administration, it also has an established record of taking a very methodical approach to the crafting of wide-reaching regulations, providing multiple opportunities for stakeholder input and feedback. Furthermore, on at least one occasion in the past, the EPA incorporated external feedback in a manner that drastically changed its biofuel GHG emission calculations, producing a new regulatory result more favorable to the industry and less attractive to many supporters of the Obama administration. Given this record, investors can expect the final, peer-reviewed version of the EPA's national fracking study to be scientifically rigorous and not necessarily influenced by the administration's partisan backers.
Investors should also realize that the EPA's national fracking study is simply the first step in a multi-year process that may or may not result in restrictions being imposed on fracking. Stakeholders will have multiple opportunities to influence both the EPA's study and any subsequent regulation, assuming the process even makes it that far during President Obama's second term. Finally, even if the EPA's study results in the imposition of restrictions on fracking, the new regulation will be susceptible to any legislative negotiations between the Obama administration and the GOP-controlled House of Representatives in the coming years. It is a significant stretch to conclude that the Obama administration will restrict shale gas production based on the currently available evidence.