Shale Gas: Investment Opportunities from the energy water investment nexus

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1 Shale Gas: Investment Opportunities from the energy water investment nexus Executive Summary Shale gas production in the US has seen tremendous growth over the last five years, leading to significant changes in the US energy sector, with far reaching impacts on the wider economy. However, shale gas extraction is highly dependent on the availability of a plentiful water supply and, to date, there has been little focus on water availability. Impax has identified significant investment opportunities in water infrastructure, water treatment and environmental consultants. These opportunities will increase as the industry is subjected to stricter water regulation and water treatment standards. Shale Gas The story so far The rapid advances in shale gas supply have been driven by the success of horizontal drilling and hydraulic fracturing technology in unlocking natural gas and liquid hydrocarbons trapped in shale deposits. US shale gas production tripled between 2007 and 2010 i and US Energy Department data shows that shale gas helped the nation meet 30% of its energy needs in 2011 ii. It is possible that the US could achieve energy independence within 10 years and the International Energy Association estimates that shale gas will constitute 32% of global gas production by 2035 iii. Figure 1: US dry natural gas production by source, (trillion cubic feet) Source: US Energy Information Administration, Annual Energy Outlook 2013 Early Release Overview, p2 The Impact on Gas Prices and Renewables Increasing supply, combined with lower demand due to a weaker domestic economy, has led to a significant fall in US natural gas prices. The Henry Hub spot gas price was as high as $14/mbtu (million British Thermal Units) before the 2008 economic crisis, falling to around $4/mbtu in 2009, before a further decline to trade between $1.82 $3.77/mbtu in 2012 iii. 1

2 This latest decline was due to the combination of oversupply, a mild winter and the growth of wet shale gas production. In the US gas now trades at approximately 11% of the value per unit of energy compared to oil (the equivalent oil price is around $18/mbtu, the equivalent gas price in Europe is around $9.5/mbtu IV.) These low gas prices have led to a dramatic drop in coal use in the US, as well as considerably lower electricity prices in many US markets. In this environment the renewable energy sector has struggled with low reference pricing in power purchase agreements, impacting profitability. However, the longer term implications of cheaper gas could well benefit renewables as the generation mix becomes more flexible and gas plants can be brought online swiftly to supply peak capacity during periods of low activity or peak demand. Figure 2: Henry Hub Natural Gas Spot Prices Source: Bloomberg, data from 31 January 2008 to 31 December Challenges & Opportunities While the availability of plentiful, cheap shale gas is challenging in the near term for renewable energy producers, it provides a wide range of interesting opportunities for companies across resource efficiency markets, particularly in the water sector. The shale gas extraction process requires between 2 and 5 million gallons of water containing a cocktail of (often undisclosed) fracking chemicals to be injected in each well v. This water has to be transported to the site, processed and injected into the well. It is estimated that billion gallons of water per year are used in the 50,000 wells in the US, the equivalent of approximately 150,000 Olympic swimming pools v. After injection, 50% to 70% of the water, with a mix of fracking chemicals and other contaminants picked up during the process, is forced back out of the well and must be treated and, or, recycled by the drillers vi. This contaminated water is generally treated and can be reused, although it will still contain residual chemicals. Today it is mainly disposed of in 2

3 deep saline aquifers. There are widespread concerns about how the industry deals with this water, which can have up to 10 times the salinity of seawater and other chemical contaminants. Given the risk to the New York City water supply, this is a major reason why fracking has been on hold in New York State and a new lengthy public consultation has been opened. The industry needs to address the issues of increasing the effective treatment of waste water as well as increasing the volume of water it recycles. Stricter regulatory oversight is expected to lead to greater treatment of contaminated water, more stringent controls around its disposal, and improved disclosure over which fracking chemicals can, and are used. Regulation Gathering momentum Most of the proposed increases in environmental monitoring or controls are expected to have relatively limited cost impacts on gas production itself. To date there has been little federal regulation of the industry. It was exempted from the US Safe Drinking Water Act and it is not expected that regulators will put excessive limitations on shale gas producers given the transformational opportunity it provides for US energy security. However, it is expected that the Environmental Protection Agency will release its delayed and much anticipated shale gas study in early 2014, which will have a particular focus on the protection of surface waters from contamination. State level regulation is intensifying and the industry is liable to scrutiny under the Clean Water Act among other legislative initiatives. It is also expected that broad based but relatively benign regulations governing fracking on federal lands will be introduced in early While this will only affect around 15% of the current wells, these rules are expected to stand as a basis for best practice for developing state level regulations vii. Of equal importance, a growing chorus of public concern for water quality and other environmental problems has substantially increased public attention on the sector, spurring some in the industry to call for tighter self regulation. Up to 4% of extracted gas (methane) can be lost in the initial drilling and completion of the well (calls for green completions ) and some gas is lost during production through inadequate casing of the well bore holes viii. This methane has a global warming potential approximately 20 times that of carbon dioxide. Regulation limiting these emissions is now becoming a major issue. In April 2012, the EPA issued federal air standards for natural gas wells that are fracked, applying to more than 11,000 new fracking wells every year, and this is expected to reduce volatile organic compound (VOC) emissions, by around 95%. States and companies will have to comply with these rules from 2015 onwards ix. Water Sector Benefiting today and more so with greater regulation A number of companies in the water sector currently have exposure to the fracking industry through water supply, sale of water chemicals, fracking pumps or associated wellhead infrastructure. For example, Aqua America, the US water utility, recently completed a pipeline supplying up to 3 million gallons per day of water to gas producers in the Marcellus shale, avoiding the need for up to 2000 daily truck journeys x. Ecolab, the specialist water and cleaning chemicals company, saw sales of $537 million to the global energy/oil and gas sector (including shale gas) in Q1 2012, a 29% growth over the previous year xi. To date there has been relatively little demand for traditional water treatment products (filtration, membranes etc.). However, this is expected to increase significantly, with higher levels of public regulation and tighter self monitoring by 3

4 gas producers, eager to be accepted into new communities or development areas. Stricter regulation will inevitably lead to the industry recycling increasing volumes of water and, in some areas, the cost of recycling the contaminated water may even be lower than the cost of supplying fresh water and subsequently disposing of the contaminated used water. Impax currently invests in sixteen companies that have strong growth potential in the water treatment sector associated with shale gas development. Example companies within the Impax investment universe include: Aqua America American Water Heckmann Veolia Weir Gorman Rupp Xylem Flowserve Sulzer Franklin Electric Ecolab (via recently acquired Nalco) Kemira Ashland Chart Industries Poseidon Concepts Supplying and removing water for shale drilling High performance pumps for injecting and removing the fracking water Chemical for treatment of produced water Wellhead cooling infrastructure Frack tanks for storing fracking fluids and water Environmental Consultants Benefiting today, and more so with greater regulation Today, a number of engineering and consulting companies are active in setting up and operating well sites, particularly water provision to fracking sites, as well as building pipelines for the produced gas and liquids. With stricter regulation, producers will require significant consulting advice in order to achieve compliance standards in the use of water, environmental assessments, site remediation, tracking gas lost to the atmosphere and monitoring well case linings. Example companies include: URS Tetratech AECOM RPS Mastec Quanta Consulting and engineering work at shale gas sites (estimate approximately $150 million of URS s revenues from shale gas last year) Pipelines gathering shale gas and liquids and connecting to demand centres (23% of Mastec revenues comes from pipeline related activities, and more than 50% of that is from shale fracking) 4

5 Testing Require tightening of standards to benefit Shale gas testing and analysis is still a relatively small market. However, increasingly stringent testing will be required for the output products from the fracking wells, and throughout various stages of the gas refining process, to ensure compliance with regulations such as sulphur content. Testing is usually contracted out to specialist laboratories and, as stricter regulation comes into force, the contaminant testing companies look set to benefit, as do the manufacturers of the testing equipment. Example companies include: SGS Intertek Bureau Veritas ALS Agilent Perkin Elmer Spectris Laboratory testing of outputs from shale wells and regulatory testing for potential pollutants Equipment for above testing Hazardous Waste Benefiting today and more so with greater regulation Hazardous waste companies see some activity today through treatment and disposal of the highly contaminated byproducts from the shale production process. This demand is likely to increase as regulation becomes stricter on the disposal of these fracking fluids. For example, the Canadian oil sands which require a high volume of processed water are already a large market for such treatment activities. Example companies include: Clean Harbors Newalta Disposals of contaminated/toxic by products Future Beneficiaries In the longer term there are many companies which look set to benefit from the fracking industry. These include large scale users of natural gas, as they gain commercial advantage from greater availability and lower cost of the fuel, and the companies that support their gas related activities. In addition, groups involved in the LNG storage and export business will benefit, including those active in efficient gas shipping. Examples of such firms include: Landi Renzo Fuel Systems Solutions Westport Innovations Clean Energy Fuels Generac Capstone Turbines Woodward (plus actual turbine suppliers such as Siemens, United Technologies, GE, Natural Gas Vehicles High Efficiency Gas Turbines 5

6 Mitsubishi Heavy industry) Wartsila Sembcorp JGC Alfa Laval Shipping/LNG In addition, the increased supply of shale gas is closing the US s six million tonne annual deficit in nitrogen fertiliser xii. The availability of competitively priced natural gas is attracting new capacity for nitrogen fertiliser manufacturing with several projects either announced or in planning stages. The potential closure of the supply deficit has profound implications for agriculture, in particular the global trade flows in fertiliser. Food for thought! Conclusion Expanding natural gas production is dramatically changing the US energy market and will have major implications for the world s future energy supply and its security. Impax believes that some of the best investment opportunities arising from the shale gas revolution are in the suppliers helping the industry to operate more efficiently, reducing pollution and meeting increasingly strict environmental controls. We could be about to witness a modern day equivalent of selling shovels during the gold rush! Investors can access growth in companies active in these rapidly developing ancillary markets. In our view these companies are often undervalued, and their growth potential as a direct result of the shale gas industry has not yet been fully recognised. There is plenty of scope for diversification, particularly within a global water or resource efficiency based portfolio. 6

7 Contact Information +44 (0) Norfolk House, 31 St James s Square, London, SW1Y 4JR Disclaimer This document has been prepared by Impax Asset Management Limited (Impax, authorised and regulated by the Financial Conduct Authority). The information and any opinions contained in this document have been compiled in good faith, but no representation or warranty, express or implied, is made to their accuracy, completeness or correctness. Impax, its officers, employees, representatives and agents expressly advise that they shall not be liable in any respect whatsoever for any loss or damage, whether direct, indirect, consequential or otherwise however arising (whether in negligence or otherwise) out of or in connection with the contents of or any omissions from this document. This document does not constitute an offer to sell, purchase, subscribe for or otherwise invest in units or shares of any fund managed by Impax or otherwise. It may not be relied upon as constituting any form of investment advice and prospective investors are advised to ensure that they obtain appropriate independent professional advice before making any investment. This document is not an advertisement and is not intended for public use or distribution. Impax is a wholly owned subsidiary of Impax Asset Management Group plc, whose shares are listed on the Alternative Market of the London Stock Exchange. Authorised and regulated by the Financial Conduct Authority. Registered in England and Wales, number Registered Investment Adviser with the SEC. Registration does not imply a certain level of skill or training. Norfolk House, 31 St James's Square, London SW1Y 4JR Sources: i Bank of America Merrill Lynch, Cracking down on fracking: shale gas & HSE risks, September 28 th 2011, page 6. ii US Energy Information Administration, Natural Gas Annual, January 7, iii International Energy Agency, World Energy Outlook Special Report on Unconventional Gas Golden Rules for a Golden Age of Gas, May 29 th 2012, Executive Summary, page 11. iv Impax internal calculations based on Bloomberg data v Bank of America Merrill Lynch Cracking down on fracking: shale gas & HSE risks, September 28 th 2011, page 27. vi Bank of America Merrill Lynch Cracking down on fracking: shale gas & HSE risks September 28 th 2011, page 30. Vii Bank of America Merrill Lynch research note, December 13 th 2012 Viii Nature, Air sampling reveals high emissions from gas field, Jeff Tollefson, 7 February sampling revealshigh emissions from gas field ix Overview of final amendments to air regulations for the oil and natural gas industry, factsheet, EPA, 17 April 2012, Page 1, x Aqua America press release Aqua America Reports Earnings for the First Quarter, February 5 th xi Ecolab press release Ecolab Delivers Strong First Quarter, Adjusted EPC Exceeds Forecase, May 1 st center/news releases/news release?id=9ea382c20c9b40aeb f xii UBS Investment Research, Engineering & Construction, What s the outlook for NA ammonia capacity?, June 4 th 2012, page 8. Deficit based on 80% of ammonia ending up in nitrogen fertiliser 7