The rapid development of oil and natural gas reserves trapped in shale and other “tight” reservoir rocks has catalyzed dramatic changes in the domestic energy picture over the past three to four years.

First and foremost, advances in directional drilling and hydraulic fracturing enabled US exploration and production (E&P) firms to tap the massive oil and gas reserves formerly trapped in impermeable reservoir rocks.

Directional drilling enables producers to target the most productive portions of a field by carving out a well that branches off horizontally from the vertical shaft. Fracturing, or stimulation, increases the permeability of the reservoir rock, allowing natural gas to flow from the reserve rock into the well. This process involves pumping large quantities of water and a small percentage of chemicals into the rock formation at high pressure, producing a network of cracks. The inclusion of a proppant–typically sand, sand coated with ceramic material or ceramic material–ensures that these passages remain open.

Not only did these production methods and technologies unlock formerly inaccessible energy resources, but these innovations also touched off a land rush that revolutionized the way in which oil and gas companies build their leasehold. Rather acquiring acreage and performing test drilling in manageable chunks, Chesapeake Energy Corp (NYSE: CHK) and other firm deployed massive amounts of capital to scoop up huge swaths of land.

Although this strategy enabled producers outmaneuver rivals and hedge against uneven productivity within a given field, it also saddled these firms with massive drilling inventories that needed to be completed by a set time to ensure that the acreage was held by production.

With ready access to capital through bond and equities issues as well as joint ventures with major integrated oil companies, E&P firms drilled these plays at a frantic pace, flooding the US market with natural gas and depressing prices to record lows for the past several years. These graphs below tell the tale.

  
Source: Energy Information Administration, Bloomberg

As you can see, US natural gas production picked up substantially in 2007 and has continued to head higher despite a corresponding decline in natural gas prices. The graphs reflect an apparent anomaly in the domestic market for natural gas: Drilling activity in unconventional plays remains robust despite depressed natural gas prices–a puzzling disconnect.

Attractive economics in some of the nation’s hottest shale plays partially explain why producers continue to ramp up production.

As my colleague Elliott Gue explained at some length in Why Some Natural Gas Is Worth $7.28, producers in the Eagle Ford and Marcellus, two shale plays rich in natural gas liquids (NGL), continue to enjoy solid profit margins. NGLs such as propane, butane and ethane tend to command a higher price that tracks crude oil; for many producers, the associated natural gas has become an afterthought. In fact, many independent E&P firms have shifted capital spending and drilling activity from dry-gas fields such as the Haynesville Shale to more profitable liquids-rich plays.

The shale gas revolution also has dramatically changed the fortunes of two related industries, one brimming with promise in the early 2000s and the other forlorn.

Earlier this decade most analysts projected that US LNG imports would increase steadily, offsetting lower domestic production. Back in 2003 there were at least two dozen proposals to build new re-gasification terminals. But US LNG imports never reached the 812 billion cubic feet per year that the Energy Information Administration (EIA) projected in its Annual Energy Outlook 2004 and have fallen off a cliff after peaking in 2007. In fact, according to the EIA, the US imported only 431 billion cubic feet of LNG in 2010, down from the 2007 peak of 771 billion cubic feet.

Source: Bloomberg

Whereas the glut of natural gas from unconventional fields proved devastating to LNG importers, this dramatic shift has helped to revivify the moribund US petrochemical production, a business that most analysts had written off because of the nation’s elevated feedstock prices.

Over the past decade, multinational chemical producers such as Dow Chemical (NYSE: DOW) have gradually shifted their production base from the US to Asia (to build a presence in growing demand centers) and the Middle East (to take advantage of lower feedstock costs).

But over the past 12 months, a number of major petrochemical producers have announced plans to restart shuttered crackers or construct world-class plants to take advantage of favorable pricing on ethane and propane, NGLs that tend to trade at a discount to crude oil but still exhibit similar price trends.

For example, Dow Chemical–the world’s second-largest chemical outfit–this year announced plans to restart its ethane cracker at its St. Charles complex, upgrading one plant in Louisiana and another in Texas to enable them to accept ethane feedstock and building a new ethylene production plant on the Gulf Coast in 2017. The firm aims to improve its ethane cracking capabilities by 20 to 30 percent to take advantage of the superior economics offered by the NGL. Royal Dutch Shell (NYSE: RDS: A) in June 2011 announced that it would build a world-scale ethylene plant in Appalachia that would source its feedstock from the Marcellus Shale.

The reason for this shift: As Stephen Pryor, President of ExxonMobil Chemical Company, pointed out in a March 8 speech, over the past five years frenzied drilling in unconventional fields has increased US natural gas production by 20 percent and ethane output by 25 percent.

Cracking facilities heat ethane and propane with steam to produce ethylene and propylene, the basic building blocks of three-quarters of all chemicals, plastics and man-made fibers.

Ethylene is a colorless gas used to synthesize polyethylene, polyvinyl chloride and polystyrene, plastics used in everything from food packaging to waterproof garments and synthetic fibers. Meanwhile, propylene is used to make polypropylene, a plastic used in electronics, automobile bumpers and consumer packaging.

Although “light” inputs such as ethane and propane accounted for about 85 percent of US cracking feedstock in 2010, NGLs aren’t the only feedstock used to produce these synthetic materials. For example, the American Chemistry Council estimates that Western Europe produces 70 percent of its ethylene from petroleum derivatives such as naphtha or gas oil. Asian cracking facilities also rely heavily on naphtha.

In short, the abundance of relatively inexpensive NGLs has revitalized the economics of ethylene and propylene production, giving US producers an unprecedented competitive advantage. Enterprise Products Partners LP (NYSE: EPD), a leading developer of NGL-related midstream infrastructure, recently highlighted this shift at the Citigroup MLP/Midstream Infrastructure One-on-One Conference. Check out this graph from the company’s presentation materials.

Source: Enterprise Products Partners LP

These price advantages, coupled with a cyclical recovery in demand that began in early 2010, enabled US petrochemicals to post fat profit margins and solid earnings growth. Meanwhile, the US also emerged as an ethylene exporter, sending roughly 20 percent of its 2010 production overseas.

But is now the time to invest in chemical companies? Rising concerns about a US recession and global economic slowdown have prompted Wall Street analysts to lower their 2012 earnings estimates for the industry. These stocks have also pulled back substantially over the past few months and, at these levels, price in the worst-possible scenario. However, the long-term growth prospects for petrochemical producers remain intact: Rising domestic demand in emerging markets will continue to generate revenue growth.

For investors seeking growth and income–as well as less volatility–midstream master limited partnerships that are building the nation’s NGL infrastructure remain some of our favorite plays in these difficult times. Investors seeking more information on Elliott Gue’s top MLP should consult the Aug. 8 Flash Alert, Don’t Panic: Opportunities Abound.