Oil and Gas in the Capitals

	Vol. 230 No. 8
JACQUES SAPIR, CONTRIBUTING EDITOR, FSU

SPECIAL FOCUS: NORTH AMERICAN OUTLOOK

Storm clouds on the horizon

Pending and proposed legislation in the US Congress has troubling implications for the oil industry, and for the entire US economy. A bill to regulate hydraulic fracturing could seriously impact nearly 90% of unconventional US oil and gas production while producing few, if any, environmental benefits. Much more seriously, in June, the House of Representatives passed its version of cap-and-trade legislation that, if enacted into law, would devastate the US oil industry.

The only hint of good news for the industry is a result of the recession. State governments in desperate financial straits are moving to approve heretofore prohibited offshore drilling as a way to increase revenues without raising taxes.

Frac restriction. Congress is considering legislation that would restrict the use of hydraulic fracturing in US oil and gas production. The legislation would repeal an exemption for “fracing” in the Safe Drinking Water Act (SDWA). Critics of the exemption contend that federal oversight is needed to protect drinking water supplies. However, the oil and gas industry argues that existing state regulation is sufficient, and that the federal EPA is not prepared to administer new regulations, which could lead to long delays, court cases and possible permit rejections.

This bill seems to be a solution in search of a problem. In 2005, Congress clarified SDWA jurisdiction in the Energy Policy Act, ensuring that state well permitting programs would continue to manage hydraulic fracturing. Although some environmental groups label this decision a “loophole” in federal law, this is inaccurate: Congress’ action merely retained a system that had worked well for more than half a century.

Over the years, the issue has been repeatedly analyzed by the Interstate Oil and Gas Compact Commission (IOGCC), the Ground Water Protection Council, EPA and other organizations. All studies found that existing regulation is effective. For example, a June 2004 EPA study found no significant environmental risks from fracing.

Also, in 1995, under then-EPA head Carol Browner (currently President Obama’s energy and climate czar), the agency concluded that federal regulation was unnecessary. In a letter rejecting federal oversight, Browner wrote, “There is no evidence that the hydraulic fracturing at issue has resulted in any contamination or endangerment of underground sources of drinking water.”

Furthermore, IOGCC found that even though 90% of oil and gas wells in the US (more than 1 million wells) have used fracing to stimulate production, there has never been even one confirmed case of contamination of underground sources of drinking water.

While the need for such legislation is open to serious question, there is little doubt about its potential impact on the industry: It would be disastrous. Obviously, fracing’s near-universal use in the US would not be occurring if it was not necessary, and restrictions or prohibitions on fracing can be expected to have serious consequences for US production. To assess the effect, the American Petroleum Institute (API) retained IHS Global Insight to estimate the potential impact on future production of proposed restrictions on fracing of oil and gas wells. The API study analyzed three scenarios:

• Implementation of regulations similar to those used by EPA to regulate the Underground Injection Control (UIC) program
• Restrictions on the use of certain fluids that are being highlighted by policymakers as having the potential to impact underground aquifers
• Elimination of fracing.

API found that these policies would cause higher prices, increased imports and negative economic impacts from reduced domestic drilling, Fig. 1. In five years, if fracing were eliminated, there would be a decrease of nearly 79% in wells completed. As a result, by 2014 the US would experience a 17% reduction in oil production and a 45% reduction in gas production, with declines continuing for decreases of 23% for oil and 57% in gas by 2018. Due to increasing reliance on unconventional wells, more than 95% of which involve fracing, the impact on production would be severe.

Fig. 1. API estimates of potential impact on US oil production from limitations on fracing.

By 2014, a change in fluid options for fracing would reduce gas production by 4.4 Tcf (22%), from 20.4 Tcf in the reference case to 16 Tcf. Crude oil production would decrease by 0.4 million bpd (8%), and wellhead revenue would decrease by $48 billion (15%). Implementation of these regulations would result in a 21% reduction in new wells drilled and a 10% loss of gas production within five years. A loss of 2.1 Tcf (6 Bcfd) would result in more imports of pipeline gas and LNG.

Thus, common sense and rigorous research indicate that legislative restrictions on fracing would have serious, permanent, negative consequences for US production and would increase energy imports. Furthermore, the benefits of such legislation may be nonexistent. Why, then, is Congress, which purports to be concerned about energy security, even considering such legislation?

In the House, the bill was introduced by Reps. Diana DeGette (D-Colo.) and Maurice Hinchey (D-N.Y.), and in the Senate, by Sens. Bob Casey (D-Pa.) and Charles Schumer (D-N.Y.). Rep. Hinchey contends that the 2005 exemption “enabled energy companies to pump enormous amounts of toxins such as benzene and toluene into the ground that then jeopardize the quality of drinking water.” In addition, some environmentalists are concerned that the water requirements of the fracing process could strain sources used for drinking water.

It is unclear how much support the bill will receive in either house, since it has not been included in the energy bills considered in the key committees. Although House Energy and Commerce Committee Chairman Henry Waxman (D-Calif.) has indicated support for federal fracing regulation, he did not allow it to be added as an amendment to the climate bill. Neither was the proposal included in the oil and gas section of the energy bill drafted by the Senate Energy and Commerce Committee.

It is not even clear if the Obama administration favors such legislation, which would retard gas development. Natural gas has relatively low CO2 emissions and is vital to the administration’s goal of reducing GreenHouse Gases (GHGs). In their congressional offices, both then-Sen. Obama and his current chief of staff, then-Rep. Rahm Emanuel, sponsored legislation encouraging natural gas vehicles, which would largely rely on unconventional resources. Without fracing, most of these unconventional resources cannot be developed.

ACESA: The 800-pound gorilla. If fracing legislation represents a troubling storm cloud on the horizon, GHG cap-and-trade legislation currently working its way through Congress represents a catastrophic Category 5 hurricane bearing down on the industry—and on the entire US economy.

On June 26, 2009, the House of Representatives passed the American Clean Energy and Security Act (ACESA)—the Waxman-Markey bill—designed to drastically reduce US GHG emissions over the next four decades. Despite the Democrats’ large majority in the House, the vote was a razor-thin 219 to 212: Forty-four Democrats voted against it and eight Republicans voted for it.

Nevertheless, it represents the first time either house of Congress has approved a bill designed to reduce GHG emissions, and thus an ominous landmark. The bill could lead to pervasive changes throughout the US economy, especially in the oil industry. The House vote also established a marker for the US when international negotiations on a new global climate change treaty begin in December in Copenhagen. As difficult as passage in the House was, it is just the beginning of the climate debate in Congress, and the issue now moves to the Senate, where political divisions and regional differences are even more pronounced, and passage of similar legislation is far from assured.

ACESA establishes a cap-and-trade system that sets a limit on total US GHG emissions, under which emissions in 2020 must be 17% below the 2005 level, and by 2050 must be 83% below the 2005 level. The cap thus grows increasingly severe over the years, increasing the price of emissions while allowing utilities, energy companies, manufacturers and other emitters to trade pollution permits (allowances) among themselves. To indicate the severity of the eventual cap, by 2050, US per capita GHG emissions will have to be reduced to the level they were in late 19th century—prior to the development of such “minor” technologies as electricity, motor vehicles, airplanes, refrigeration, air conditioning, televisions and computers.

According to Rep. Waxman, a co-sponsor and the driving force behind the bill, “This legislation will break our dependence on foreign oil, make our nation a leader in clean energy jobs and cut global warming pollution. The bill’s provisions forcing reductions in the use of fossil fuel while increasing production of alternative energy sources would produce millions of new jobs.” However, these statements are open to serious question.

The bill reported out of committee was 940 pages long, eventually grew to more than 1,500 pages by the time it passed the House, and was still being revised at 3 a.m. the day of the vote. It is thus unlikely that anyone who voted on it had read the bill, much less understood it.

Make no mistake: This may be the most far-reaching piece of legislation in US history, and it will give government a level of influence on the economy it did not even possess during World War II. The bill would promulgate over a thousand new regulations and mandates, establish vast new bureaucracies, commissions and regulatory boards, drastically increase energy costs, and result in trillions of dollars of new taxes. It would impact every facet of economic life: energy, utilities, banks, vehicles, appliances, buildings, industry, agriculture, transportation, commerce, etc. According to a recent column in The Washington Post, a newspaper that supports climate change legislation, “it would be difficult to implement even in Sweden.”

According to a recent analysis by the Science Applications International Corporation (SAIC), ACESA would cause US energy prices to more than double—and in some regions the increases would be much greater—would cause annual GDP losses of $700 billion, and would result in the loss of more than four million jobs. Of course, there would also be many new jobs created: jobs for bureaucrats, regulators, lobbyists, lawyers, traders, speculators, etc. The few dozen people who actually understand the bill, the Capitol Hill staffers who spent years writing it, stand to become immensely wealthy as lobbyists and consultants.

Despite overwhelming evidence of the bill’s economic costs, these estimates are often dismissed by advocates as being biased and “paid for by big business and big oil.” It is thus significant that a recent report by the Washington D.C.-based Brookings Institution verifies the magnitude of the potential impacts on the economy and the oil industry. The left-leaning research institute is the oldest (founded in 1927, with roots dating back to 1916) and one of the most influential think tanks in D.C., and it supports climate change legislation.

Brookings notes that the impact on the coal industry would be especially devastating: By 2025, the cost of coal would more than double; coal production in 2025 would be 40% lower; and by 2025, jobs in the coal sector would decline by nearly 50%. This is hardly surprising, since it is widely recognized that the coal industry would be seriously affected by GHG control legislation. However, importantly, Brookings finds that the US petroleum sector would be almost as severely affected: By 2025, the cost of crude oil would jump 40%, production would drop more than 40%, and jobs in the crude oil sector would decline by nearly 40%, Fig. 2.

Fig. 2. Brookings Institution estimates of ACESA impacts.

Over the next four decades, Brookings estimates that the bill would result in a wealth transfer via allowances of $9.2 trillion, with all of the government bureaucracy, regulation, rent seeking and gaming (see the European experience) this implies. Note that this is wealth transfer, not wealth creation. Given even modest estimates of fees and commissions, lobbyists and Wall Street traders stand to make $1–2 trillion from ACESA, money that would represent an enormous net drain on the US economy.

If this bill becomes law, US oil companies will likely react by closing US facilities, reducing capital spending and increasing imports. Under the bill, refiners would have to purchase allowances for the CO2 produced by their plants and by vehicles using the fuel produced. However, imports would require permits only for the latter, which would give foreign sources the opportunity to bring in transportation fuels at a lower cost. The same amount of gasoline that would have $1 in carbon costs imposed if it were domestic would have 10 cents less added if it were imported. This will have an adverse impact on US industry, force the closing of refineries, and cause a reduction in investment and jobs. Thus, the bill would incentivize US refiners to import more fuel, and API predicts that one-sixth of US refineries would close by 2020 as the cost of carbon allowances increases. So much for the “Energy Security” portion of the bill.

State offshore drilling. One bright spot on the horizon is that coastal states are rethinking their opposition to offshore drilling. It is all about money: The recession has wreaked havoc on state budgets, especially California’s, and coastal states view offshore drilling as a revenue source.

California. Governor Arnold Schwarzenegger has proposed allowing the state’s first offshore oil drilling lease since 1969, for Plains Exploration & Production (PXP), an independent producer based in Houston. The state is facing a $26 billion deficit, and Schwarzenegger notes that the PXP proposal for drilling off Santa Barbara would be “environmentally responsible” and would produce $100 million in 2009–2010 revenue and $1.8 billion over the next 14 years.

The Tranquillon Ridge project would use slant drilling and allow production under state waters from the PXP Irene Platform in federal waters, and the company expects to extract 105 million barrels of oil in the 14 years that would be allowed if the proposal is approved. In return, PXP has agreed to permanently shut down four oil platforms off the southern California coast and two onshore processing facilities in Santa Barbara by 2022, and to donate 4,000 acres of land for public use.

Schwarzenegger has focused on the oil-rig shutdowns and near-term revenue from the Tranquillon Ridge project, but he also argues that it would redirect money to California that would otherwise go to Washington. The governor argues that if oil is going to be produced from California’s seabed, the state should get some of the royalties; otherwise, “We might as well be writing Washington a check.” A small fraction of the 240 million barrels of oil California produced last year came from the state’s offshore fields, while production from federal waters off the state’s coast produced twice that amount.

Nevertheless, some environmental organizations, including the Sierra Club, and community groups in Santa Barbara oppose the project on environmental grounds. They also contend that the amount of revenue involved is not significant. Perhaps only in California could potential revenues of nearly $2 billion be termed “not significant.”

Florida. Reversing a 19-year-old ban on drilling in state waters to protect beaches and tourism, the Republican-controlled House has voted to open Florida’s coastline to exploration. Under the proposal, Gov. Charlie Crist could negotiate with energy companies to allow drilling from 3 to 10.3 miles off Florida’s coastline. However, the proposal faces an uncertain political future. The Senate still has to approve the plan and Mr. Crist, a Republican who has forged his political image on pro-environment policies, has weighed in carefully, calling the idea “intriguing.”

Supporters predict the state would see a multibillion-dollar windfall from royalties and severance taxes. Before exploring Florida waters, companies would have to submit a nonrefundable $1 million fee. The money would be used in part for a $300 million land-buying program, Florida Forever, and for grants to local communities for beach restoration. The state government currently faces a $7 billion deficit and is searching for new sources of revenues.

Federal estimates indicate that there are 1.6–2.8 billion barrels of oil off Florida’s Gulf Coast, in addition to substantial gas reserves. The shallow waters—60–80 ft—are ideal to produce oil and gas quickly and easily.

Virginia. Virginia’s gubernatorial election, to be held in November, is usually considered a bellwether national referendum on the party that won the presidential election the previous year—this time the Democrats. Republican candidate Bob McDonnell and Democratic candidate Creigh Deeds, who scored a stunning, decisive primary upset over Clinton confidant and party fundraiser Terry McAuliffe, both support offshore drilling.

The issue was given legs by a recent independent report on Virginia’s offshore energy resources prepared by the Thomas Jefferson Institute for Public Policy. The report found that offshore exploration and drilling are environmentally safe, widely supported by the public, and would produce significant economic benefits for fiscally strapped, tax-averse Virginia. It found that even a conservative estimate of 90 billion barrels of oil off the Virginia coast would be enough to meet Virginia’s oil needs for 400 years. Virginia currently imports nearly all of its petroleum products, with 50% of imported petroleum coming from overseas. An API survey found that 70% of Virginians support increased offshore development. WO

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