It’s heartening to see stories about US unconventional natural gas finally make their way into the mainstream media. The US shale gas revolution has been underway for more than a decade, but until recently, few outside the energy industry understood its scale and importance.

Many are still surprised to learn that thanks to prolific production from plays such as the Haynesville Shale in Louisiana and the Barnett Shale in Texas, the US appears to have overtaken Russia to become the world’s largest producer of natural gas. At one point in early 2008, US gas production was growing at a double-digit pace; it wouldn’t be a stretch for US producers to match that growth rate again if there were enough domestic demand to support higher output.

As XTO Energy (NYSE: XTO) chief Bob Simpson recently put it in a hearing before a House Subcommittee, “the psychology of the natural gas markets has turned from one of scarcity to one of plenty.”   

This is a true sea change in outlook: Just five years ago, most pundits were discussing the need for the US to import more gas in the form of liquefied natural gas (LNG) to meet demand. Now, US LNG import facilities sit idle and the talk centers around potential new ways to use domestically produced gas or, ironically, the opportunity to export North American gas to energy-hungry markets in Europe and Asia.

But press attention is a mixed blessing, and I cringe every time there’s a headline about shale gas in a major newspaper. On Dec. 3, 2009, The Washington Post ran a front-page, above-the-fold piece entitled “An Energy Answer in the Shale Below?” The article went on to describe the process of producing shale gas and the economic benefits of the country’s newfound gas.

But the piece ended with a lengthy discussion of the controversy surrounding the practice of hydraulic fracturing or “fracking.” A follow-up article in the same issue focused solely on the environmental impact of this prospect. Controversy keeps readers’ interest and sells newspapers; just about every article I read about shale gas devotes an inordinate amount of space to the environmental consequences of fracturing.

Unfortunately, the controversy about fracturing leads some investors to believe that Congress is ready to ban the technique. But these fears are overblown. Although greater oversight of the practice is possible, it’s unlikely to kill the US unconventional natural gas boom. In fact, the climate on Capitol Hill appears to be improving for natural gas, not deteriorating.

How it Works

Casual observers of the energy markets are often under the impression that oil and natural gas exist underground in giant caverns and must simply be pumped to the surface. But that’s not how geology works. Oil and natural gas are typically found underground inside the pores, cracks and crevices of rock; hydrocarbon-bearing rock in an oil or gas field is known as reservoir rock.

Sandstone is a typical conventional reservoir rock. As the name suggests, sandstone is comprised of sand-like particles and tends to be both porous and permeable. In other words, sandstone has a large number of pores that can contain gas, and those spaces are well connected, making it easy for the gas to flow through the reservoir.

Natural gas reservoirs are naturally under significant geologic pressure. When a producer drills into a conventional field, the well creates a link to the surface where pressures are much lower. The rest is simple physics: The oil or gas flows through the reservoir rock and into the well, moving from a region of high pressure to one of lower pressure.

But many of the most-talked-about unconventional plays in the US are comprised of shale, a dense and fine-grained rock made of layers of clay particles or mud. Producers have understood for decades that shale can contain natural gas–and, for that matter, crude oil–but it was widely thought to be irrecoverable. Wells drilled into shale would produce a quick rush of gas but quickly die off; the gas output just wasn’t high enough to make these wells economic.

The problem is that shale is dense and impermeable; no matter how much natural gas is in the shale layers underground there is no way for that gas to flow through the shale and into a well.

Two key technologies have unlocked shale: horizontal drilling and hydraulic fracturing. By drilling horizontally through unconventional rock formations, producers can expose more of their well to productive shale zones.

Hydraulic fracturing involves pumping a liquid into the reservoir under tremendous pressure; this actually cracks the rock, creating passages for the gas to flow through the formation and into a well. In short, fracturing improves the permeability of the field. Producers also usually introduce what’s known as proppant–typically sand, sand coated with resin or ceramic material–into the fracturing fluid. As the name suggests, the proppant actually enter the cracks caused by the fracturing and holds or “props” those cracks open. This prevents the newly formed cracks from closing as soon as pressure is removed.

The active horizontal and directional rig count–a measure of the total number of rigs actually drilling horizontal wells for gas–is a good indicator of the level of activity in North American shale plays and the prevalence of fracturing. The graph below provides a closer look.

Source: Bloomberg

To calculate the data points in this graph, I divided the number of directional and horizontal drilling rigs actively working in the US by the total number of rigs at work. As you can see, less than 30 percent of the rigs working in the US were rigs capable of drilling directional and horizontal wells at the turn of the last decade. Now, close to 65 percent of rigs in the US boast these capabilities.

And this chart likely underestimates the extent and importance of fracturing because many vertical gas wells are also treated with the same technology. In fact, industry estimates suggest that more than 90 percent of all new gas wells are fractured.

Environmental Concerns

The most often voiced environmental concern surrounding fracturing is that the fluid used to fracture unconventional wells might migrate through the reservoir rock and contaminate underground aquifers, polluting drinking supply.

And many of the most prolific unconventional gas shale plays are located in regions of the country that don’t have a modern history as energy-producing states. For example, the Marcellus Shale extends across broad swathes of Pennsylvania, New York, Virginia and West Virginia–far from the Gulf Coast hub of the US oil and gas industry.

And drilling also occurs in areas that are more densely populated than the traditional oil and gas-producing areas of the US. Both factors, quite naturally, give rise to controversy.

Traditionally, natural gas producers have been reticent to disclose the exact composition of the fracturing fluid used in a particular region. This information is somewhat of a trade secret, and companies are constantly tinkering with the exact mix of fluid in an effort to maximize production. Naturally, companies don’t want their competitors to benefit from their hard work and expensive trial-and-error research.

But it has become clear that one of the biggest issues for residents in shale-producing areas is the mysterious composition of fracturing fluid. As a result, industry opposition to the disclosure of fluid composition has softened notably. Oil service giant Schlumberger (NYSE: SLB)–a company that handles fracturing work for scores of major producers–has asked permission from its suppliers to disclose the chemicals it uses in fracturing fluid.

And last autumn, Chesapeake Energy (NYSE: CHK), one of the largest and most active producers of shale gas plays in the US added a section to its website detailing the sort of chemicals it uses in fracturing fluids.

What’s in fracturing fluid is less interesting and far less scandalous than some are making it out to be. For starters, fresh water and sand make up roughly 99 to 99.5 percent of fracturing fluid. The sand is used as proppant and is the same basic product that has been used in construction projects for hundreds of years. It’s the remaining 0.5 percent of the mix that’s the subject of most concern.

The following table presents the information Chesapeake Energy has provided concerning fracturing fluid constituents.

Source: Chesapeake Energy

Although some chemicals in this list shouldn’t be found in drinking water, fracturing fluid is hardly a concentrated cocktail of toxic chemicals. As the table indicates, most are relatively common in industrial and/or household products.

But what’s more important than the make-up of the fracturing fluid is the manner in which unconventional gas wells are drilled. Different rocks are deposited in layers underground, and these layers run roughly horizontally and parallel to the ground. For example, the Haynesville Shale of Louisiana is typically found at a depth of 10,000 to 14,000 feet below the surface, and the productive shale layers are anywhere from 200 to 500 feet thick.

In this case, a producer targeting this play would drill vertically down to the shale and then sideways directly through the shale layer. The horizontal segment of the well is designed to travel through the most productive portion of the play. All of the fracturing in the well would be performed along the horizontal section of the well where the shale is located.

But freshwater aquifers are found roughly 1,000 feet or less below the surface. There is certainly no drinkable water located at a depth of 10,000 or 14,000 feet. Accordingly, wells used to tap these aquifers would be located more than 10,000 feet (roughly two miles) away from drinking water supplies. In between the aquifer and shale layers are multiple layers of solid rock of different composition.

Of course, the vertical portion of the gas well does travel through the aquifer on its journey to the Haynesville (or any other shale play). But, when wells are drilled, producers routinely install a thick steel pipe known as casing around the well to prevent the well from collapsing. In addition, the casing prevents undesired fluids–such as water–from leaking into the well and inhibiting production. That casing is cemented in place to isolate zone such as aquifers from the well.

It’s all-but-impossible for fracturing fluids injected into a formation 12,000 feet underground to migrate through two miles of rock and into an aquifer if a well has been properly installed and cased.

Of course, there are certain risks inherent in any activity; no matter how mundane, no activity is truly 100 percent safe. The incidents most often cited to as proof of the supposed dangers of fracturing concern Cabot Oil & Gas’ (NYSE: COG) projects in the Marcellus Shale in Pennsylvania. Some residents in the region reported natural gas in their water supply, and state inspectors found that some of Cabot’s wells were improperly cemented, possibly allowing natural gas to leak into the aquifer.

This, of course, is not a problem unique to unconventional gas drilling. The use of casing and cement to isolate aquifers from fluids being produced from deeper layers of rock is close to a century old. The same producer was also suspended from operations after its contractors apparently spilled some fracturing fluids on the surface. This incident is hardly a condemnation of the practice of fracturing.

Other reported incidents of natural gas or fracturing fluids polluting water supplies appear to stem from coal bed methane (CBM) wells. Coal seams often contain natural gas, which producers can extract using fracturing and other techniques.

The problem with CBM wells is that these gas deposits are typically located relatively close to the surface–in some instances, just a few hundred feet from freshwater aquifers– raising the odds of fluid migration from the coal seam to the water supply. CBM activities should be more of a concern than deep shale gas plays.

Prospects for Regulation

As part of a 2005 energy bill, Congress exempted fracturing chemicals from the Safe Drinking Water Act. That exclusion came after a detailed study from the Environmental Protection Agency (EPA) in 2004 concluded that fracturing posed little or no risk to drinking water. As I noted earlier, firms aren’t required to disclose what’s in their fracturing fluids, though I suspect you’ll see more voluntary disclosure in future to allay the public’s concerns and dispel the air of mystery that still surrounds fracturing fluids.

Individual states already regulate fracturing and drilling activities. Some, such as New York, have proved rather hostile to the practice; others, such as Pennsylvania, have openly embraced the money and jobs gas drilling brings.

In fact, Chesapeake Energy announced last October that it was the only leaseholder in the New York City watershed and had no plans to drill any natural gas wells on these leases. The company stated that it prefers to concentrate on its properties elsewhere in New York State where the Marcellus Shale is more prospective.

Some in Congress clearly resent that the energy industry won this exclusion in 2005, and others dispute the EPA’s 2004 findings as flawed. Late last year Congress asked the EPA to review the practice, and over the past year bills were introduced in both the House of Representatives and the Senate that address some of the concerns about fracturing.

The most prominent piece of legislation targeting fracturing is the Fracturing Responsibility and Awareness of Chemicals Act introduced last June. This act would repeal the exemption from restrictions afforded to the energy industry as part of the 2005 bill and would force oil and gas companies to disclose the proprietary mix of chemicals used on fracturing.

The co-sponsor of this legislation, Representative Diana Degette (D-CO), recently defended her proposals in a hearing before a House Committee and noted that the bill would require companies to disclose the constituents of their fracking fluids without revealing the exact formula. She argued that everyone knows what is in Coke but the exact formula has remained a trade secret. She went on to stress that she supports the use of hydraulic fracturing; in fact, she repeated that phrase twice for emphasis.

At a January hearing before the House Energy and Environment Subcommittee, members questioned the CEOs of both XTO Energy and ExxonMobil (NYSE: XOM) about their recently announced deal. Due to its size, ExxonMobil often becomes a scapegoat for politicians looking to assign blame for high energy prices, but the tone of the questions was surprisingly positive. Two Representatives from Pennsylvania–Republican Joe Pitts and Democrat Mike Doyle–both spoke at length about the environmental benefits of gas and the prosperity unconventional gas production from the Marcellus Shale has brought to their state. 

Representative Doyle went so far as to say that the tie-up between XTO and ExxonMobil would improve the technology of gas production and “herald a fundamental long-term shift in energy markets.” As part of the deal with XTO, Exxon has an “out” clause. The agreement states Exxon can back out of the acquisition if Congress were to make the practice of unconventional drilling illegal or commercially impractical. Doyle’s comments suggest he’s not looking to place any onerous regulations on fracturing that could imperil the deal.

Despite the rumblings from some local environmental groups, neither side of the aisle has expressed an interest in rendering hydraulic fracturing uneconomic. The equation is simple. Without fracturing, there is no unconventional gas production–and without production from these fields, the nation’s dependence on foreign energy would send gas prices and energy bills soaring. And many representatives–Republican and Democrat alike–hail from regions that enjoy significant job growth and investment thanks to shale gas.

Regulation of fracking won’t bring in the votes. In fact, adding incentives to encourage gas use or gas production might be just the sweetener needed to attract more votes to an energy bill.

Even many environmental groups support the practice, noting that the benefits of replacing dirty coal with clean-burning gas outweigh the risks of contaminated drinking water. On the national level, one of the biggest supporters of increased natural gas drilling and use is the Sierra Club, an environmental group many associate with anti-industry views.

Investors in natural gas and related companies should not worry about onerous regulations from Washington. Congress is increasingly looking like a friend rather than a foe of the gas industry. And the political reality of the Democrats loss of Super-Majority in the US Senate is that they’ll be looking for bill sweeteners to attract bi-partisan support rather than unpopular measures that would stall legislation.

Race to the Summit

A panel discussion on the state of the economy. Presentations by each of our expert editors. One-on-one time with those experts. A sunset cruise of San Diego Bay…

April 23-24 could be your most important weekend of the year. Roger Conrad, GS Early, Yiannis Mostrous, Benjamin Shepherd and I will reveal the brightest trends and our best recommendations–and anything else you might want to know–during the 2010 Wealth Society Member Summit at the historic Hotel del Coronado.

They say it’s 72 and sunny every day of the year in San Diego, and in late April it probably will be. Tranquility and relaxation is good; that and the best independent view of global investing make a great combination. You may find all details at www.InvestingSummit.com.

Call 1-800-832-2330 (between 9:00 a.m. and 5:00 p.m. EST Monday through Friday) or go online now to reserve your seat at the table. Space is limited.