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The "State" of the Shale Play in the United States: A Look Back on 2012 and What to Expect in 2013

Alerts / February 4, 2013

During 2012, several states adopted new statutory and regulation programs addressing the exploitation of shale resources within their boundaries. Continuing a common election year theme, Congress took no significant formal action with respect to energy, let alone shale, in 2012. In addition, little was done from a regulatory perspective at the federal level although the U.S. Environmental Protection Agency (EPA) stirred controversy with its final air toxics rule for the oil and gas industry and its ongoing efforts to connect groundwater contamination to hydraulic fracturing activities.

Simply put, the states stole the show in 2012. Some states completely revamped their statutory and regulatory oil and gas programs (e.g., Ohio and Pennsylvania) while others continued to evaluate potential impacts (e.g., New York). It is evident that most states with shale resources are keenly aware that responsible shale development can have positive, synergistic effects on the economy and job growth, and have taken swift action to facilitate the development. Finding the right balance, whether from an environmental protection or revenue generation standpoint (i.e., taxes), has proven to be a difficult task, and it is reasonable to expect significant "fine tuning" of existing state programs in 2013. In addition, some states have already taken significant steps in 2013, (e.g., Colorado) and it is reasonable to expect "big things" from the New York State legislature in 2013.

State courts also continued to play a significant role in 2012, as disputes over ownership of shale gas rights continued to weave their way through the courts, and local governments fought to retain local jurisdiction over shale development in the face of state law preemption. There is little doubt that the courts will continue to play an important role in 2013.

In our discussion below, we assess some of the key shale related developments of 2012. We also forecast what to expect in 2013 on a number of fronts – legislative, regulatory and judicial. Throughout 2013, we will be tracking these issues closely and reporting them on our blog, www.NorthAmericaShaleBlog.comSubscribe to the blog and sign up to receive timely updates sent to you.

2012 SHALE DEVELOPMENTS

Federal

Legislation

Congressional attention in 2012 was diverted largely to election-related issues and, as a result, Congressional overhaul of shale regulation was pushed to the back burner. Some have advocated for a uniform set of federal rules that would provide clarity and consistency to the marketplace, however, the few proposals that were floated in the 112th Congress (and have been floated since 2008) died quietly. In addition, because we expect the 113th Congress to focus chiefly on more hot-button political and fiscal issues such as the budget, deficit reduction and immigration, it is unlikely that meaningful statutory revisions will occur in the coming year. For now it seems that the desire for uniformity and federal oversight is outweighed by state interests in a more localized approach tailored to the policy concerns, natural resources, and political, economic and geologic conditions in each state.

Regulatory

The Energy Policy Act of 2005 exempted hydraulic fracturing activities from regulation by the EPA under the Safe Drinking Water Act, unless the fracking fluids used contain diesel fuel. As a result, the EPA lacks much authority to regulate the practice directly. Because of this, the EPA and other federal agencies such as the U.S. Department of the Interior (DOI) have chosen to take action where they have clear statutory authority to regulate shale development and have operated indirectly to regulate shale drilling otherwise.

In May, the DOI's Bureau of Land Management (BLM) proposed federal rules governing hydraulic fracturing on federal / public lands that largely comport with the approaches of many states. The draft rules also contained well integrity requirements to verify that fracturing fluids are not escaping into nearby water supplies, as well as requirements for management of large volumes of flowback. The BLM’s proposal faced heavily critical comments by industry trade organizations and various states; these parties contend that states are effectively regulating hydraulic fracturing, and BLM's rules would only serve to delay permitting and increase drilling costs. In response, BLM announced in December that it would reconsider its proposed rules and would not re-issue them until sometime in 2013.

In May, the EPA released draft Underground Injection Control (UIC) Class II disposal well permitting guidance for oil and gas hydraulic fracturing activities using diesel fuels. The EPA's guidance document focused on what information would be useful in permitting the underground injection of oil- and gas-related hydraulic fracturing using diesel fuels (in instances where the EPA is the permitting authority). The EPA accepted comments on this guidance through August of 2012.

In August, the EPA published final air regulations revising the New Source Performance Standards (NSPS) and National Emission Standards for Hazardous Air Pollutants (NESHAP) for the Oil & Natural Gas Production source category. The final rules include federal emission standards for hydraulically fractured natural gas wells, as well as requirements for oil and gas industry sectors for which no federal air standards previously existed. One key component of the revised NSPS involves the use of a process – known as a "reduced emissions completion" or "green completion" – to capture natural gas that currently escapes into the air. Some states already require such emission capture processes. But the final rule allows oil and gas sources until January 1, 2015, to conduct green completions using a phased approach to allow sufficient time for cost-effective control equipment and trained operators to become broadly available. Several public comments on the proposed rules, including those by the American Petroleum Institute, indicated that these controls are not sufficiently currently available. Until 2015, the final rule requires fractured and refractured wells to reduce their VOC emissions by 95 percent through combustion devices (flares).

The EPA’s air rules predictably drew several legal challenges. In October, nine different challenges were filed in the D.C. Circuit by environmental groups and industry trade associations. And in December, seven northeastern states (led by New York) filed a notice of intent to sue the EPA under the Clean Air Act, claiming that agency's new regulations do not adequately address methane emissions. Industry representatives also have objected to the new rules, claiming that the new requirements for vessels are unworkable and that the mandated emission control technologies are not currently available and will not be available in time for implementation.

The EPA also has focused on long-term projects, such as continuing investigations into groundwater contamination claims made by owners of private drinking water wells in Dimock, Pennsylvania, and Pavillion, Wyoming. At Dimock, the EPA conducted several rounds of testing of water from approximately 60 area homes to determine whether the water was contaminated by nearby shale operations. In separate announcements in March and July, the EPA found that the water did not contain levels of contaminants that would pose health concerns and deemed the town’s water safe. The EPA’s December 2011 draft report, attempting to link chemicals from a Pavillion aquifer and water wells to area gas fields, was met with heavy criticism from state regulators and industry – prompting the agency to issue a revised report in October and recently extend public comment on the revised report until September of this year.

Finally, the EPA announced early in 2012 that it will use its authority under Section 8 of the Toxic Substances Control Act (TSCA) to adopt regulations that require companies to disclose information regarding "chemical substances and mixtures used in hydraulic fracturing." The EPA’s announcement was prompted by a 2011 petition filed by several environmental groups that focused on requiring chemical manufacturers to provide information on all substances used in the exploration and production of oil and gas. An advanced notice of proposed rulemaking under TSCA Section 8 is expected sometime this year.

The States

Legislation and Regulatory

Absent comprehensive federal regulation, and without extensive history and experience to use as a guide, states took varying approaches to regulating shale development in 2012. These approaches continue to evolve, becoming more nuanced as states gain experience and familiarity with hydraulic fracturing techniques.

Not every state welcomed shale development with open arms. In almost every state where hydraulic fracturing regulations were considered (such as Ohio, Illinois and California), a complete moratorium on the practice was at least proposed. Most states considered moratoria in order to allow state agencies to study the issue and develop regulations. Vermont was the only state with an enduring position to ban the practice altogether. But this ban will have little impact on shale exploration. Vermont does not possess significant access to natural gas formations and, therefore, the ban is largely symbolic.

New York and Maryland currently have moratoria in place, but their governors and state regulators have been careful to characterize them as a temporary pause pending further study and review. Maryland's environmental agency is developing regulations to govern hydraulic fracturing and is expected to publish those regulations in 2013. And New York not only released draft hydraulic fracturing regulations in November, but also leaked a draft health assessment a few weeks ago indicating that shale drilling can be conducted safely.

Many more states opted to regulate shale development rather than curtail it entirely. Following the lead of early adopter states such as Wyoming, Texas and Montana, in 2012 many states in key shale plays updated their oil and gas programs, both statutory and regulatory, to address hydraulic fracturing, including: Texas (Jan. 2012), New Mexico (Feb. 2012), Pennsylvania (Feb. 2012), Colorado (April 2012), North Dakota (April 2012), Ohio (June 2012), Oklahoma (March 2012- effective in 2013/2014) and Indiana (June 2012).

These states also adopted comprehensive regulations and expanded the scope of the disclosure requirements. Although the timing of disclosure requirements varies widely, states like Texas typically imposed more comprehensive disclosures than those sought by early adopter states, including, among other things, the source of water or base fluids used; total volume of fluids used; all additives by trade name, supplier, and descriptions of their use, function or purpose; and Chemical Abstract Service (CAS) numbers for each chemical ingredient. Additionally, many states, including Texas, Colorado, Pennsylvania and Oklahoma, impose disclosure requirements on vendors and service providers and require coordinated reporting and disclosures between operators and service providers (such as Texas, Colorado, Pennsylvania and Oklahoma).

The important issue of addressing proprietary or trade secret information in fracking fluids also varied widely. Some of these recent adopters rely on their own state law for the definition of a trade secret, and by doing so either limit the ability to claim a trade secret, or specifically define the exceptions to a claim of trade secret, or both (Texas).

The Courts

These new programs and their resulting implementation have in some instances led to divisive litigation. The most noteworthy suits in 2012 arose in Pennsylvania in response to the state legislature’s enactment in February of Act 13, which repealed Pennsylvania’s Oil and Gas Act and replaced it with a wide-ranging series of oil and gas regulations. One of Act 13’s provisions required localities to amend their zoning ordinances to allow oil and gas operations in all zoning districts -- including residential zones. Localities and other parties challenged that provision on the grounds that it forced localities to enact zoning ordinances that are incompatible with their comprehensive plans and incompatible with neighboring land usage, effectively making their zoning irrational. In August 2012, Pennsylvania’s Commonwealth Court in the Robinson Township case overturned those portions of Act 13, holding that the bill impermissibly pre-empted local zoning regulation of oil and gas activity in violation of substantive due process under the U.S. and Pennsylvania constitutions. The Court also overturned a separate provision allowing state officials to waive local setback requirements for gas wells, but the remainder of the legislation remains in effect. The state appealed, and the Pennsylvania Supreme Court heard oral arguments on October 17, 2012.

Oil and gas rights in the new shale plays are lucrative. Sorting out those rights has been a litigious matter in recent years. Clearly, oil and gas rights that at one point were considered to have very little or moderate value now are hot commodities. The day before oral argument in the Robinson Township case, the Pennsylvania Supreme Court heard argument in Butler et al. v. Charles Powers Estate. In Butler, the court must determine whether shale gas rights are included as part of an oil and gas reservation of rights to "minerals and petroleum oils" -- in other words, whether shale gas counts as a "mineral" under state property law. Under the longstanding Dunham rule, which has governed transactions involving subsurface rights in Pennsylvania since 1882, a provision in a deed reserving "minerals" without mentioning natural gas or oil creates a rebuttable presumption that the grantor did not intend to reserve natural gas or oil rights. If the Court overturns the Dunham rule, many already-negotiated transactions involving subsurface rights likely would be called into question, throwing the leasing of shale gas rights into disarray.

A pre-emption scenario is playing out in Longmont, Colorado. Longmont’s city council adopted rules in the spring governing local oil and gas operations (including shale wells). In response, the state of Colorado sued the city, contending that the city’s rules were pre-empted by state oil and gas rules. While that case was pending, voters in Longmont passed a ballot initiative in November banning hydraulic fracturing and associated waste disposal in the city. Rather than challenging the new ban directly, though, Colorado opted not to sue Longmont but indicated it would support other parties if they wanted to challenge the ban. A state industry group did just that in late December.

2013 SHALE DEVELOPMENTS AND PREDICTIONS

Looking forward to 2013, the prospects of federal legislative action to expand the EPA’s ability to regulate shale drilling appear dim. In a sharply divided 113th Congress focused primarily on other ssues, serious legislative efforts to regulate hydraulic fracturing remain unlikely. For example, Rep. John Shimkus, chair of the House Energy & Commerce Committee’s environment panel, issued a statement on January 3, 2013, stating that his subcommittee will prevent the EPA from subsuming state regulation of hydraulic fracturing and shale development.

Absent legislative action, federal agencies will continue to act within their existing regulatory authority to regulate where they can. EPA Administrator Lisa Jackson and Secretary of the Interior Ken Salazar recently resigned their posts, and President Obama has yet to nominate replacements. Although the President’s choice for these slots could portend the pursuit of a more aggressive agenda as to environmental and natural resources regulation, Republican opposition and larger policy fights may limit that possibility. The DOI is expected to re-launch its rules for drilling on federal lands in the new year. Similarly, the EPA recently announced that it would seek to put the challenges to its oil and gas air rules on hold by agreeing to revise the rules to address concerns raised by industry and state stakeholders. And while the EPA recently issued a progress report on its hydraulic fracturing study, the final results of its study will not be available until sometime in 2014.

At the state level, Pennsylvania’s Supreme Court will decide the Butler and Robinson Township cases in the coming months. The Court’s decisions could reshape the application of real estate and zoning laws in Pennsylvania to shale drilling. But the Court’s current makeup of eight justices split 4-4 along party lines increases the likelihood that both lower court decisions will be upheld. If that occurs, the zoning and setback provisions in Act 13 would be invalidated, sending Pennsylvania’s state legislature back to the drawing board to address those issues.

We also believe New York will lift its existing moratorium on shale drilling. The timing and content of the state’s recently-released draft hydraulic fracturing regulations indicate that New York likely will reauthorize drilling in some fashion, either statewide or in certain designated jurisdictions. Based upon the state’s draft regulations, the environmental review requirements associated with hydraulic fracturing (and therefore the permitting costs) are likely to be significant compared to other states, such as Pennsylvania and Ohio. If New York lifts its moratorium, the fact that some localities in New York pre-emptively outlawed hydraulic fracturing while the moratorium was in effect could lead to contentious litigation over the enforceability of those local bans.

More states will amend their oil and gas laws in 2013, either legislatively or by regulation. These state regulations will continue to evolve, becoming more nuanced as states continue to learn from their counterparts what works and what doesn’t. Large states near emerging shale plays, such as California and Illinois, have yet to overhaul their regulations, but bills are pending in their state legislatures to do just that. Colorado is the most recent state to update its rules, as it became the first state in the nation to require both pre-drilling and post-drilling groundwater testing for new shale wells. Colorado regulators also implemented expanded setback requirements for well locations statewide, and announced the launch of a study concerning the character and behavior of air emissions from upstream oil and gas operations. And California’s Department of Conservation released in December a "discussion draft" of regulations that would govern hydraulic fracturing in the state. The draft regulations include requirements for pre-fracture well integrity testing, pre-fracture notice requirements, pre- and post-fracture monitoring and chemical disclosure. Under the rules, oil and gas well operators seeking to protect trade secrets would be required to demonstrate, among other things, that disclosure would compromise a significant economic advantage. The draft regulations also would make spill reporting, response and clean-up requirements clearly applicable to fracturing fluids.

State taxation of shale development also is an issue gathering steam in key shale states, as state governments attempt to strike a balance between encouraging much-needed economic development and achieving needed influxes of revenue — chiefly to fund state regulation of hydraulic fracturing and/or to offset proposed tax cuts in other areas. Ohio will be a key flashpoint state in 2013 on this topic. In last year's legislative session, Republican Governor John Kasich proposed implementing increased severance taxes on newly-permitted wells as part of the state's overhaul of its oil and gas laws; the Governor's tax proposal went nowhere in a Republican-controlled legislature loath to increase any taxes. Undeterred, Gov. Kasich has vowed to push this issue in the 2013 session. If he succeeds, governors in other key shale states may be emboldened to propose similar tax schemes.

Another emerging issue states are beginning to face relates to the disposal of flowback and other fluids from the hydraulic fracturing process. For most of these fluids, the only viable disposal option is in Class II injection wells. For example, Pennsylvania does not allow disposal of flowback in Class II injection wells, while neighboring Ohio does. Concerned about becoming a dumping ground for these wastes, Ohio only recently began issuing permits for injection wells under revised state rules. Whether Ohio or other amenable states have the capacity and the willingness to accept high volumes of these wastes is an issue that may arise in the coming year.

As drilling continues to expand nationwide, litigation inevitably will grow out of these developments. The Butler case is but one example of an increasing trend of landowner suits as to the validity of transfers of shale rights. And as state and local governments attempt to regulate all aspects of drilling, disputes will arise, both as to how regulations are implemented and who has primary authority to regulate. Longmont, Colorado, already has seen multiple lawsuits concerning these very issues. In that vein, distribution of regulatory authority for traditionally local issues (such as nuisance, noise and road maintenance) is becoming an emerging issue for a number of state and local governments. The Robinson Township case is the obvious example of such a dispute, but similar actions already have occurred in Colorado and Texas, and easily could emerge in 2013 in states such as Ohio and New York where drilling will ramp up in the coming year.

It is reasonable to expect that 2013 also will be a year where transportation infrastructure begins to catch up with the pace of drilling, particularly in areas such as Ohio and eastern Pennsylvania where gathering lines, processing facilities and other related infrastructure continues to be a bottleneck to development. In Ohio, several companies have proposed gathering lines, transmission lines and processing plants in the Utica Shale region, and many more comparable proposals are in the works.

Through our blog, the North America Shale Blog, we will continue to track these and many other shale-related developments in 2013 as they unfold.

ADDITIONAL INFORMATION

We hope you find this information helpful. If you have any questions about the material presented in this alert, please contact any member of BakerHostetler's national Shale Practice.

Authorship Credit: Martin T. Booher, Jason E. Yearout, and Cassie J. Dallas


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