Amplified concern

“We have to be willing to wade into industries, even in developed markets, where wild and sometimes dangerous things are happening,” James Coulter, co-founder of TPG, said during a speech late last year. He was making the point that private equity firms needed to identify sector dislocations to find the best opportunities and ticked off four ‘wild areas’ TPG was wading into, including horizontal drilling and shale gas plays. “Never has a right hand turn changed so much,” Coulter told the crowd. “You cannot overstate how this is changing the gas market in the US … there will be a lot more gas compression and pipelines.”

TPG is certainly not alone in its thinking. Numerous private equity firms have been cashing in on the enormous potential of natural gas deposits under shale rock formations – the most recent example being Kohlberg Kravis Roberts’ exit in June of Hilcorp Resources, which held acreage in South Texas’s Eagle Ford Shale natural gas deposits. The firm had spent $300 million in June 2010 for a 40 percent stake in the Texas-based company; that was quickly turned into $1.13 billion when Marathon Oil purchased the company for $3.5 billion.

But the bonanza may be tempered by environmental concerns. Activists have raised questions about the method by which natural gas is extracted from shale. A mixture of water and chemicals is shot into shale formations, breaking up the rock layers and releasing deposits of natural gas. The process, called hydraulic fracturing, or fracking, has drawn the ire of environmental groups who claim it could contaminate groundwater supplies.

The issue has been particularly contentious in the American Northeast, where the Marcellus Shale offers a large deposit of natural gas. Fear of groundwater pollution prompted New York to adopt a seven-month moratorium on fracking in December, for example.

“There has been more concern raised as drilling activity has moved East about environmental issues and that’s a risk we all have to be cognisant of,” says Steve Webber, co-chief executive officer of Avista Capital Partners, which last month committed up to $125 million for a controlling interest in Sidewinder Drilling, a firm that operates drilling rigs for exploration and production companies. “The prospect of changing regulations heightens risk and could cause investors to choose to divest earlier in the development cycle. However, the more important driver is internal rate of return.”

As shale exploration has become more wide-spread, criticism has amplified. Fracking regulations are being implemented on a state-by-state basis, so investors can simply avoid states considering restricting the process, Webster says. Regulatory efforts have been more muted in regions already accustomed to the presence of the natural gas industry, like the Gulf Coast.

Still, even in seemingly oil and gas industry-friendly states like Texas, regulations are popping up. Texas’ Legislature in May passed a law requiring companies to disclose the chemicals used in fracking. Congress, meanwhile, is looking into the matter, too: a bill that would require companies to disclose the chemicals used in fracking and comply with the Safe Drinking Water Act was reintroduced to the US House of Representatives and Senate in March.

So far it seems the federal discussion is progressing towards regulation, but not an outright ban on fracking like some states are considering or have enacted. At a Senate hearing in April, Bob Perciasepe, deputy administrator at the Environmental Protection Agency, noted that if produced responsibly, natural gas had “the potential to improve air quality, stabilise energy prices, and provide greater certainty about future energy reserves”. But he noted that “If improperly managed, natural gas extraction and production, including hydraulic fracturing, a technique for extracting natural gas, may potentially result in public health and environmental impacts.”