How to Invest for Potential Fracking Regulation

energyThe following article was published on on January 23, 2012.

Michael Filloon of Seeking Alpha has a five-part article series on investing for potential of EPA regulation of fracking as a result of public concerns about water usage and contamination. Below is a synopsis of his excellent analysis, but for an in-depth assessment of how to invest, be sure to read his series.

Hydraulic fracturing or “fracking” is an industry practice of pumping a pressurized mixture of water, quartz sand, and proprietary chemicals. An average well requires 80,000 gallons of water for drilling, the fracturing process requires 3.8 million gallons of frac mixture, and one million gallons of water is returned to the surface and is currently trucked to treatment centers. Various environmental groups are concerned with the use of millions of gallons of water and the potential to contaminate the local ground water.

While the industry is too vital and too profitable to be affected by these concerns, this could lead to Environmental Protection Agency (EPA) regulations and fracking changes. These changes will affect other elements of the industry including transportation of frack water, on-site clean water supply equipment, and alternative fracking fluids. These changes are where the opportunity to profit lies.

Concern from groundwater pollution has not officially been deemed an issue by the EPA. There is precedent for concern though. Chesapeake contaminated 16 families’ drinking water and was ordered to pay $900,000 and Encana has to provide safe drinking water for 21 households. A Denbury well reported leaking at one of its sites. There were no issues with the leak found, but it opens the possibility in the public’s mind.

So what areas of change are expected to receive tighter regulations? One is the proper placement of cement casings to prevent accidental leaks. Another could be dimensional and structural pits for catching leaks and runoffs and containing them. The third is the chemicals that go into fracking fluids. The fracking recipes are tightly held by the industry, but a push to safe or biodegradable chemicals is likely. Fourth is a separation and processing of frac water so the water can be returned to the natural supply. Fifth is the amount of frac water allowed to be left underground when the process is complete. Recognizing these upcoming changes leave opportunities for profit if you find the correct industries early.

You have to role-play in your mind a little the effect of these likely changes. If the majority of the changes is a push to returning fresh water to the local water supply what industries will this impact? One would think companies that are creating onsite treatment centers like General Electric (GE) and its mobile evaporators. Mobile treatment centers would remove sand and grit (with the possibility of reuse), remove metals, kill bacteria, and remove salts. This water could then be reused for another well at the same site.

If the producers of these mobile treatment plants can prove that the process pays for themselves with reduced transportation and treatment costs you will see a very fast rate of growth in the industry. It would also suggest bearish sentiment on transport companies that profit by transporting the water (currently about 200 trucks per well) offsite to be stores or treated. If the majority of the impact is in output regulation, that would suggest bullish sentiment on companies that provide testing like Xylem because it may be cheaper to show that you are not polluting the area then changing your current process.

The more regulations, containment, and treatment required the more expensive the whole process becomes. Eventually this opens the window to research and capital costs associated with changing to new “green” fracking chemicals. Flotek is one company creating new age fracking chemicals called microemulsifiers has already gained traction before new regulations. Another chemical play is Newpark with 7.5% market share, but 81% within the United States. Newpark has the potential to expand within the US on green technology and internationally.

To play devil’s advocate to all the smaller company plays is the rate of growth in the industry. The buyer of all these products, the drillers, will want to take advantage of every new well opportunity it is allowed. A killer of many new products is the inability to produce at the rate of growth in the industry. If the political leanings move towards domestic energy production companies like Heckmann Corporation (HEK) which is large, established, and has the ability to respond quickly could be poised to profit because it has the ability to get the wells producing quickly regardless of new technologies. Also, they have the capital to purchase new proven technologies and implement them quickly.

The energy sector has many opportunities to profit. Regulations change the field by breaking the status quo and giving smaller nimble companies the chance to gain market share and kill other industries that haven’t created a flexible business plan. By investing in these companies before the regulations are forced on the industry you can catch the large upside jump when the rest of the investing community piles on. Regardless if you choose to short drillers because there will be more expenses put on them, invest long with chemical companies or on-site water treatment companies, you should not ignore the impact of epa regulations and fracking on the industry.