Do Fracking Companies Face Regulatory Risks?

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We recently learned that Ohio geologists are formally announcing their belief that there is a causal link between earthquakes and fracking. While those who follow the industry have already been aware of this suspicion, there have been no formal proclamations that have potentially threatened the industry until now. If state geologists are asserting that a link exists, it matters less whether this is actually the case and more that this could lead Ohio and potentially other states to adopt restrictive legislation that adversely impacts the companies that are involved in fracking.

For those unfamiliar with the practice, fracking, or hydraulic fracturing, is a process whereby shale rocks are fractured in an attempt to extract oil and gas. While the practice is more than a century old, it has recently become a popular method of oil and gas extraction in the United States. This is the case after there were several discoveries made by companies operating in the middle parts of the country. Two notable finds are the Eagle Ford shale region in southern Texas and the Bakken region in Montana and North Dakota.

Some of the companies that have the bulk of their operations in one or both of these regions have seen tremendous sales and profit growth over the past few years.

  1. Oasis Petroleum (NYSE:OAS) has grown its revenues grow ninefold over the past three years.
  2. Continental Resources (NYSE:CLR) has grown its revenues fourfold over the past three years.
  3. EOG Resources (NYSE:EOG) has seen its revenues more than double over the past three years.

It goes without saying that these stocks have generated tremendous returns for investors who got in early.

As a result of this oil and gas boom in the U.S., it has been a bright spot in a generally lackluster economic environment. Furthermore, the fact that energy production in the United States is increasing is extremely beneficial, economically and politically. It will lower energy prices, and it means that we are getting less of our energy from the Middle East, Russia, and Venezuela. A politician who can claim that we achieved energy independence under his or her leadership will have no trouble achieving re-election.

If we juxtapose this with the environmental concern that fracking causes earthquakes, we see how regulators face a dilemma. Do they restrict fracking and effectively destroy jobs and wealth that is so rapidly being created, or do they risk heightening the probability that the country will experience a devastating earthquake or series of earthquakes caused by fracking?

The fact that Ohio geologists are formally addressing the environmental concern means that we are more likely to see higher regulations and restrictions on fracking.

This is potentially bad news for investors in “fracking stocks,” such as those mentioned above. While no action has been taken to restrict fracking, even the possibility can lead investors to sell of their shares of these companies. For investors that are invested in fracking companies, or for those investors who are thinking about investing in these companies, here are a few tips.

First, hold energy companies that don’t engage in fracking to hedge the risk of holding those that do. Energy is an essential part of any investment portfolio, given how important it is to the global economy. There are innumerable ways to get exposure to energy that don’t involve fracking:

  • Oil and gas companies that don’t engage in fracking
  • Coal miners
  • Pipeline and oil/gas transport companies
  • Uranium miners
  • Oil and gas service companies
  • Electric utility companies

The list goes on, but the point has been made. Investors who want to hold, say, 15 percent of their assets in energy-related companies can buy three companies, one of which engages in fracking. At worst, fracking will be outlawed completely, and the stock will go to $0, and the investor will lose 5 percent of his or her capital. At best, fracking restrictions will be limited, and the companies engaged in fracking can continue to grow their sales and profits at incredible rates. Reality probably lies somewhere in between these two extremes.

Second, look for companies that don’t get all of their revenues from fracking. Apache (NYSE:APA) is an excellent example of a quality name that is aggressive in the Eagle Ford shale region, but which also has a diversified portfolio of oil and gas assets. The stock is forming a nice base just below $80 per share (it currently trades at $82 per share), and it should see rising profits due to a high oil price and production growth. If fracking is heavily restricted, Apache will undoubtedly suffer. But it is far from doomed in my aforementioned worst-case scenario.

More conservative investors should consider companies such as Exxon Mobile (NYSE:XOM), which engages in fracking but which has its tentacles all over the world. Even if fracking were to be completely banned across the United States, Exxon Mobile would be just fine.

Ultimately, no matter what investment you make, you are going to have to face some sort of regulatory risk or the risk of government restrictions. The risks are always there, but sometimes they become front-page news. More than deterring investors, this should encourage them. Fear of regulation is no different than any other sorts of fear that prompt investors to sell an investment. Chances are that restrictions on fracking will be limited, and the top fracking companies will not face any serious problems. But at the same time, when “Fracking Causes Earthquakes” becomes a national headline, we could easily see the shares of these companies fall dramatically.

As someone who holds stocks in a variety of energy companies, I welcome this as an opportunity to diversify into some of the fastest-growing and most profitable companies in America at low prices.

Disclosure: Ben Kramer-Miller is long Exxon Mobile.

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