November 2013, Vol. 240 No. 11


Need For Infrastructure Among Challenges Outside Of U.S.

Dallas Parker, Partner, and John D. Furlow, Associate, Mayer Brown, Houston, TX

(Editor’s note: This is the second of two parts. Part 1 was published in the P&GJ October edition.)

Outside the U.S., the lack of a large-scale pipeline network and related infrastructure makes getting oil and gas to market difficult, and sometimes cost-prohibitive. A recent McKinsey & Company report estimates it will take up to $1.4 trillion in infrastructure investment to complete the necessary pipelines, rail networks, and drilling and gathering infrastructure necessary to fully capture the potential of the shale revolution in the U.S. The investment required to take advantage of a global shale revolution will certainly be even greater.

As such, the comparative cost of building additional pipeline is one of many important factors in gauging the pace at which a global shale revolution could take place. U.S. producers have benefited from a comparatively lower cost per mile for building additional pipeline – between $1-4 million per mile. Some international pipeline projects can cost upward of $15 million per mile.

The market and price for the hydrocarbons produced is the other side of the equation. The U.S. has a highly developed market and pricing system for oil, natural gas and other hydrocarbons – trading, swapping, hedging, futures, Henry Hub, etc. In particular, the pricing system in the U.S. gives companies important price signals. Initially, high natural gas prices encouraged the use of high-cost unconventional drilling methods in places like the natural gas-rich Barnett Shale. Today, lower gas prices are shifting the focus to areas with “wet gas” (natural gas with hydrocarbon liquid content) and tight oil, because natural gas is selling at a 75% discount to oil, based on energy content, and is more expensive and difficult to export.

U.S. financial markets also provide producers numerous tools for hedging risk. These tools are not always available elsewhere. Many companies looking at investing in India’s shale resources, for example, are concerned not only about limited infrastructure, but also about the ability to market their production and hedge risk in the highly regulated and controlled midstream and downstream markets for natural gas.

Even in the U.S., where costs of production are generally lower, the narrow margins involved in shale production have led to problems. Notably, when the price of natural gas dropped below $2 per thousand cubic foot in April 2012 (thanks, in large part, to the success of the shale revolution), some energy companies with higher costs of production or lease obligations that forced them to drill, faced financial stress because the costs exceeded the available market price. Natural gas prices have since rebounded, floating around $4 since October 2012.

In addition to production costs and market price, access to capital and financing has been particularly important for companies operating in U.S. shale plays. According to Ernst & Young, the top 50 operators invested $186 billion in shale play development during 2012. An IHS report estimates the U.S. unconventional oil and gas industry will raise $5.1 trillion of additional capital over the next two decades. E&P companies operating in U.S. shale plays have been able to grow and expand rapidly, in part, due to the diverse financing options available to them for raising capital, including: public equity, private equity, convertible securities, private placements, high-yield debt and conventional or mezzanine bank financing.

E&P companies operating in the U.S. shale plays have also been able to employ a number of flexible legal structures that have enabled rapid capital expansion, such as joint ventures, master limited partnerships and royalty trusts. There are a lot of legal considerations in structuring oil and gas financing and corporate transactions, particularly those involving shale assets. Without flexible legal structures and diverse financing options, E&P companies operating in the U.S. shale plays would not have been able to raise the capital to make the large-scale shale development possible.

Ownership Of Minerals
The U.S. is one of the few countries that recognizes the right of individuals to own oil, gas and other minerals (Canada also recognizes this right; however, private mineral ownership in Canada is considerably less widespread than in the U.S.). The legal principle of private ownership is expressed as “Cujust est solum usque ad coelem et ad infernos” (to whomever the soil belongs, he owns also to the sky and the depths). In nearly every other country, including “common law” countries, title to all valuable oil, gas and mineral deposits belongs exclusively to the “sovereign,” i.e., the national government.

In the U.S., producers have benefited from high landowner support because they generally have a financial incentive to support development instead of fight it. Oil and gas companies often pay mineral owners substantial royalties, rentals and bonuses in exchange for a mineral lease. This aspect of the shale revolution has even spawned a new term –“shaleionaire,” a name for landowners turned into millionaires overnight with a shale lease.

Even when a U.S. surface-owner does not own the “minerals” (the “mineral estate” can be “severed” from the “surface estate” in the U.S. so there can be surface owners who are not mineral owners and vice-versa), oil and gas companies typically offer “surface use” payments that can amount to tens of thousands of dollars per drilling site. Without private mineral ownership abroad, there is little incentive for landowners to accept the risk and inconvenience of drilling; as a result, landowners outside the U.S. are among the chief opponents of shale development.

This unique aspect of American law has led to some interesting results. Despite the seemingly higher transactional costs associated with negotiating with tens of thousands mineral owners, shale development has progressed primarily on private lands in the U.S.

Legal, Regulatory Certainty
There is a point at which the regulatory burden placed on oil and gas development outweighs the incentives to produce. This is particularly true for shale development because it involves more financial risk and higher production costs than conventional oil and gas production.

To date, U.S. producers have enjoyed a comparatively favorable legal and regulatory environment. In particular, they have benefited from a clear body of judicial precedent, developed over decades, that provides clarity on most oil and gas issues. It is also relatively easy to have a well permitted and the costs of regulatory compliance are not yet cost-prohibitive.

This is not to say that shale development does not face legal and regulatory obstacles in the U.S. The average application for a permit to drill on federal lands was estimated to take over 300 days in 2011. By comparison, it takes an average of five days in Texas (which allows expedited permits in two days), seven days in California, 10 days in North Dakota, 14 days in Ohio and 27 days in Colorado. Also, the time period between the date the lease is signed and when actual production begins is typically one to two years on private and state lands. Drilling on federal land, however, can take up to 10 years. Consequently, despite the unprecedented increase in total U.S. oil and gas production over the past decade, production on federal lands has actually declined since 2003.

In addition despite the economic benefits of the shale revolution across the U.S., hydraulic fracturing is still controversial among some. In the mid-2000s, several environmentally oriented interest groups and individuals emerged to challenge the use of the hydraulic fracturing process. They generated widespread concern in many communities by, among other things, asserting that the process posed a direct threat to groundwater. In particular, opponents alleged that hydraulic fracturing fluids and chemicals injected into deep geological strata had the ability to migrate upward through thousands of feet of impermeable rock and were contaminating groundwater formations located just below the surface. These groups and individuals argued that natural gas could make the same journey and contaminate groundwater. Unlike the longstanding and easily mitigated production risks of a blowout or a spill at the surface, this claim struck at the process itself.

To date, hydraulic fracturing has been used more than one million times in the U.S. since the late 1940s without a single verified instance of this type of contamination. This was acknowledged by former Environmental Protection Agency Administrator Lisa Jackson in 2011, as well as regulators at the Bureau of Land Management, the Department of Energy and at least 10 states, including Colorado, Pennsylvania and Texas. Moreover, a significant amount of scientific research has been conducted on this issue in recent years, and no evidence has been found of any direct link between hydraulic fracturing and subsurface groundwater contamination. Still, concerns about the use of chemicals in the process persist in many communities.

There have been several regulatory responses addressing the rise in the unconventional drilling in the U.S. The most significant regulatory trend over the past three years has been the adoption by about 20 states of hydraulic fracturing fluid chemical disclosure policies. Along with disclosure policies, many states have also adopted additional well construction, casing, cementing and other standards to ensure that groundwater is not affected.
Overall, greater transparency regarding the fracturing process has resulted and helped to dispel a number of concerns about the potential environmental effects. With the dispersion of additional information about hydraulic fracturing, public debate in the U.S. has shifted decidedly in favor of shale development. Indeed, with the exception of Vermont, which has no known shale resources, state legislatures have consistently rejected efforts to ban hydraulic fracturing (New York and North Carolina maintain “temporary” moratoria on the process, and Maryland’s governor has issued a hold on applications to drill in western Maryland, thus creating a “de facto moratorium”).

Notwithstanding the common refrain that shale development is “unregulated,” the fact is that all oil and gas development is subject to a web of federal, state and local regulations. In terms of the regulation governing shale development, U.S. producers have benefited from the fact that exploration and production is regulated primarily by state agencies, many with decades of experience in the oil and gas industry. The Railroad Commission of Texas (despite its name the agency no longer regulates railroads), for example, has been regulating oil and gas production since the 1920s and is nationally and internationally recognized for its expertise.

The experience and expertise of these state agencies has helped provide certainty and ensure regulation is effective, technically feasible and not overly burdensome. Without significant shale production anywhere else, other countries will continue look to the American experience when forming plans and policies for developing their own shale resources.

The lack of legal and regulatory certainty overseas has served as a major impediment to a global shale revolution. Among the top concerns cited by energy companies are:

• The cost, length of time and unpredictability associated with permitting exploration and production activities
• The risk of a ban or moratoria on hydraulic fracturing (e.g., France and Bulgaria)
• Restrictive environmental laws (particularly in Europe)
• Generally inexperienced regulatory agencies
• The risk of nationalization (e.g., Argentine nationalization of Repsol YPF);
• Labor market restrictions
• Import regulations (e.g., barriers to importation of drilling rigs in Europe)
• The lack of clearly defined intellectual property protection laws

Environmental concerns about the safety of hydraulic fracturing, and the resulting risk of new laws or regulations restricting its use, have been among the most significant barriers to shale development abroad. France and Bulgaria cited environmental concerns when banning the use of hydraulic fracturing in 2011 and 2012, respectively. Efforts to develop shale have also been stalled, although not banned outright, through regulatory measures in other countries, such as Germany and Austria. The effort to restrict shale development seems to be ebbing and a number of moratoria on hydraulic fracturing have been recently repealed, including those in the United Kingdom, Romania, Australia (provinces of Victoria and New South Wales) and South Africa (the Karoo Basin).

Many countries have already realized the economic reality of shale development and are taking active steps to develop resources. China has an estimated 1,115 Tcf of technically recoverable shale gas reserves (about double the U.S.’s reserves, according to the EIA). China’s National Energy Administration wants to see production of 230 Bcf of shale gas a year by 2015 and as much as 3.5 Tcf by 2020. So far, progress has been slow. As of May 2013, only about 60 shale exploration wells had been drilled, all in the preceding two years. The same number is drilled in North Dakota every 10 days.

Chinese companies are eager to learn from the American experience with shale development and bridge the technical divide by, among other things, investing in and entering in joint ventures with American energy companies operating in U.S. shale plays, such as the recent $1.7 billion Sinochem-Pioneer joint venture in the West Texas Wolfcamp Shale.

The U.K. provides another example. After lifting a temporary moratorium on hydraulic fracturing in December 2012, the U.K. has taken steps to incentivize shale gas exploration and production by, among other things, proposing a reduction in the tax burden placed on onshore shale gas exploration and production.

The Prognosis
Despite obstacles, the answer is an unequivocal yes. The benefits of shale development are too large to ignore. In regard to the much-discussed environmental concerns, there is a growing body of scientific evidence demonstrating that the risks are overstated and can be safely managed. Although it will take time, science and economics will win out in the end and overcome the most significant barriers to shale development – the political ones. Advances in technology will overcome many of the technical, geologic and cost obstacles hindering development.

In the end, the real question should not be “if,” but “when.” That answer is admittedly more complex. A global shale revolution will not accelerate as rapidly as it did in the U.S. It will happen piecemeal, gradually over the course of the next several decades with the pace of development varying widely by country.

Authors: Dallas Parker is a partner in Mayer Brown’s Houston office and is co-head of the firm’s Global Oil and Gas Practice Group. He represents U.S. and other clients in corporate and securities law matters, with experience in the areas of mergers, acquisitions, dispositions and public and private offerings of securities. He earned his law degree from University of Texas School of Law and his bachelor’s degree from Vanderbilt University.

John D. Furlow is an associate in Mayer Brown’s Global Oil and Gas Practice Group in the Houston office. He earned his law degree from University of Texas School of Law and his bachelor’s degree from Vanderbilt University.

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